Taxation – Salary or Dividends?
Salary or Dividends?
The way a bonus is paid has a significant effect on corporate and personal after-tax income.
You are an owner-manager and you’ve just had a really good year. Profits are up significantly and you want to reward your employee shareholders with a bonus. But how? Salary or dividends? The answer to this age-old question is not as simple as it seems. It is even possible to receive remuneration that is a combination of salary and dividends. However, because every company and its shareholders have different needs, a “one size fits all” approach to remuneration is not prudent.
Salary and dividends differ with respect to taxation. A dividend is a per-share payout of retained earnings and is therefore not an expense and thus does not reduce pre-tax income. A salary bonus differs from a dividend in that it is an expense and thus reduces pre-tax income. Corporations, trusts, charities and a wide variety of other entities can also receive dividends.
Different Tax Effects
Distributing a salary bonus effectively reduces pre-tax income by the amount paid. Thus, if a company pays out 100% of pre-tax earnings in the form of a salary bonus, the corporation may not be subject to income tax expense. On the other hand, if a company wishes to distribute the same dollar amount of earnings by declaring a dividend, the company must first pay corporate income tax. Assuming after-tax earnings of $100,000 and a tax rate of 15.5%, the cash outlay would be $118,343 (i.e., the distribution of the $100,000 of earnings in the form of a dividend bonus plus the $18,343 in income tax on those earnings in order to net $100,000 for the dividend payment).
Dividends are often cited as the best means of providing remuneration to the owner-manager since they do not attract as much personal income tax as salary. For example, a salary of $100,000 for a single individual would create a combined federal and provincial tax of $26,466 (Ontario), whereas an eligible dividend of $100,000 from an owner-managed business would generate a personal tax of $9,802; personal tax from an other than eligible dividend would be $16,693.
At first blush, an owner may be tempted to simply pay out all profits by dividend because of the significant personal tax savings. However, since dividends are paid from after-tax earnings, the combined tax in the case of an eligible dividend would amount to $28,145 ($18,343 + $9,802) and in the case of an other than eligible dividend the combined tax would be $35,036 ($18,343 + $16,693). Certainly there are other factors that come into play both on a corporate and personal level, but the example establishes that one should carefully consider the approach to be taken.
There are additional considerations that must be factored into the decision as to whether to pay dividends or salary.
- Because dividends are not earned income, they cannot be used to create any RRSP contribution room.
- Because dividends are not earned income, they do not create any requirement for a contribution to the Canada Pension Plan by either the owner-manager or the employee.
- Financial institutions often lend on the basis of earned income believing that salary is the only way to judge an individual’s ability to pay. Attitudes in this area are certainly changing, but income based on corporate dividends may impact your ability to obtain personal mortgages or lines of credit.
- If the employee is unable to work because of an accident or some other event, a wage replacement amount may be difficult to calculate because dividends are not earned income.
- Income splitting that is possible by paying salary to family members employed in the business will be hampered if the family members are not shareholders since dividends are paid to shareholders on a pro rata basis.
- Insurance companies may not be willing to support benefit or disability programs if dividends paid to an organization’s owner cannot be included in their definition of earned income.
- Receipt of dividends instead of salary may nullify other personal income tax deductions such as child care expense.
- Various provincial bodies may include dividends when calculating the employer’s Workplace Safety and Insurance Board (WSIB) or Employer Health Tax liability.
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