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Paying yourself a salary out of your business entitles you to many benefits. They are as follows:
- 1. Contributions to the Canadian Pension Plan through employment income plays an integral part in your retirement consideration and it depends upon how much and how long you contributed to this plan.
- 2. Entitles you to participate in RRSP (depending on your age) which is the best strategy to defer your income tax liability and it enables you to pay less tax in future when you have lower taxable income.
- 3. Paying salary would also decrease the taxable income of the corporation as it’s a tax deduction.
- 4. You can also pay a salary to your spouse or children in another tax strategy called income splitting although you must follow CRA’s defined rules. To know these rules please visit Tax Planning Strategies.
On the downside, paying yourself a salary from your business has few disadvantages the obvious one being that since your salary income is 100% taxable if your taxable income falls in higher tax band it would increase your tax burden.
Your liability for CPP contribution would also increase as you are both the employer and the employee.
Treating yourself as an employee means you must maintain payroll records and set up Payroll account with the CRA. After year end you must issue T4 slips.
Paying dividends out of your own business have following advantages:
- 1. Dividends are taxed at a lower rate than salary, so you will pay less personal tax.
- 2. You don’t have to contribute to CPP
- 3. Getting income out of the business through dividends is simple as you would only write a cheque to yourself at year-end, update the corporation’s minutes’ book and prepare the director’s resolution for dividends paid.
As far as disadvantages are concerned, not contributing to CPP would reduce your CPP amount entitlement upon your retirement. Not having employment income means you can’t contribute to RRSP.
Receiving dividends instead of salary means you will lose some personal income tax deductions like child-care expense deductions.
So, which one is the better option?
Each option has its own pros and cons. So, choosing one of these options is dependent upon the following factors:
- 1. The financial condition of the business owner i.e. if business owner’s taxable income is already in higher tax band then paying dividends is a better option.
- 2. The cash flow needs of the business owner. This will help to decide based upon tax deferral strategies available in each option.
- 3. The corporation’s estimated income for the year. Whether it is generating a smooth income over the years or there are fluctuations.
- 4. The importance of RRSP and other personal tax deductions to the business owner.
- 5. What is the age of the business owner?
Assessing the impact of these factors on each option is tricky and it’s better to take professional advice from an experienced accountant or tax consultant.