DIVIDENDS vs. SALARY for Small Business Owners in CANADA
One for the common dilemmas the small business owner is facing when the tax season approaches, is whether to get paid by dividends, or by payroll, putting on the scale total money outcome for both the individual, and the corporation.

Many of us have heard or read that first 40k of dividends are essentially tax-free for an individual. Being such an attractive perspective, most of us can just wonder, how did he or she not come across that valuable information earlier, and why the accountant has not told anything?

A little bit of theory should be reviewed first, in order to do that, let us use Ontario tax rates in our examples, for the specific tax year, and assume that the owner and the corporation are both located in same province. Please also refer to the notices at the end with respect to information used in this article.

Salary/wages are an expense for your corporation, and are income to you as an individual. With small business corporation rate approximately equal to 15.5%, assuming it is located in Ontario, the company will save 6.4k in income taxes after paying a 40k salary, in case it has a net income for that year. An individual, who is Ontario resident, receiving 40k income, will pay on average 7.6k in CPP and Tax. The company will pay it's part of CPP of 1,807 dollars on top. Adding 7.6k with 1.8k we have an approximate 9.4k tax cost for the company and employee together.

Dividends have to be paid out of company income, and in order be able to do that, enough net income needs to be declared before the dividends can be paid. If that is the case, the company will have to pay 6.4k of income tax on 40k net income. Then the recipient will be issued a T5 slip with the following numbers:

BOX 10 Actual amount of dividends 40,000
BOX 11 Taxable amount of dividends 50,000 ( 40,000*1.25)
BOX 12 Dividend tax credit 6,670

 Taxable amount of dividends of 50,000 is also called a grossed up amount of dividends as 40,000 is multiplied by the factor of 1.25 in order to arrive at the amount that will be included as your income on line 150 of your personal tax return.

Dividend tax credit is calculated as 13.3(3) % of taxable amount of dividends, and in our case is equal 6,670. Due to this credit, along with the personal basic tax amount, the tax that you pay on the first 40k of dividends is 667 dollars.
Thus, in total we get around 7.1k in total tax cost for owner and the company.
This is only true, however, if the dividends were your only income. The matter gets more complicated if we have a combination of several types of income. The most common scenario would be a mix of salary and dividend income.
Let us review an example where you already have some salary, and now need to make a choice between paying salary/bonus, or go with the dividends.

Suppose you are single, live in Ontario and you already got 31,500 salary during the year, from which you have properly deducted:

Tax: 4,075.4
CPP: 1,386
EI: 0 (You are exempt if you are the owner and director)

Then,

- if you pay yourself Dividends of 25,000:

T5
BOX 10: actual amount paid: 25,000
BOX 11: taxable amount of dividends: 31,250
BOX 12: dividend tax credit: 4,166.56
Then your line 150 total income will be calculated as combination of salary of 31,500 and taxable dividends of 31,250, and be equal to 62,750
Balance of tax on the personal tax return in this case is 3,369.05
Potential additional income tax for corporation will be around 3,995

 OR

- if you pay yourself a salary bonus of 25,000:

 Then your line 150 total income will be: 56,500
Balance of individual tax owing 6,995.08
Additional tax for corporation is the employer portion of CPP Contribution of 776.38

 Therefore, in case of salary/dividends mix, you get much less tax advantage if you go with dividends.

As mentioned above, the 3,995 corporation income tax is potential and must not necessarily be incurred in the same year. The dividends need to be paid from income of the corporation, and you will need to show at least 25,000 net income in your corporation, or you declared this much income in previous years, and your Retained Earnings Account has already that much positive balance. If you have to declare net income this year, you would pay an approximate 15.5% of 25000.

Dividend Sprinkling
There are certain advantages in income splitting strategies using dividends. Under specific conditions, the attribution rules will not apply directly as they do in case of salaries paid to family members. One of such strategies is "dividend sprinkling", where family members are issued different classes of voting and non-voting shares, and each class is assigned dividends according to the shareholder's tax bracket.

Eligible Dividends
We should note, that the Income Tax Act differentiates between eligible and other than eligible dividends. Eligible dividends are the dividends paid from the income that was taxed at the large corporation tax rate, so there was no federal and provincial small business deduction. For corporation operating in Ontario this would mean additional 17.5% of tax, bringing the average rate from 15.5% to approximately 33.5%. The recipient of eligible dividends will pay less personal tax on them. For the small business corporation, however paying eligible dividends is not practical, and therefore other than eligible dividends are usually paid. These are referred simply as dividends in this article.

Here are the tax values for Salary and Dividend Income for the range between 20k and 100k a year, assuming Ontario provincial tax.

Salary / Gross Pay............Tax & CPP.............CPP - Company Part........................Total Tax Cost
...........20,000..........................2,356.30...........................816.80.......................................3,173.10
...........30,000..........................5,057.10........................1,311.80.......................................6,368.90
...........40,000..........................7,618.80........................1,806.80.......................................9,425.60
...........50,000........................11,030.60........................2,301.80.....................................13,332.40
...........60,000........................14,189.00........................2,356.20.....................................16,545.20
...........70,000........................17,304.00........................2,356.20.....................................19,660.20
...........80,000........................20,742.10........................2,356.20.....................................23,098.30
...........90,000........................24,657.90........................2,356.20.....................................27,014.10
.........100,000........................28,998.80........................2,356.20.....................................31,355.00
.........200,000........................74,356.40........................2,356.20.....................................76,712.60


Dividends Paid......Dividend Personal Tax......Corporation Income Tax.................Total Tax Cost
...........20,000..........................300..........................................3,200......................................3,500
...........30,000..........................390..........................................4,800......................................5,190
...........40,000..........................667..........................................6,400......................................7,067
...........50,000.......................2,236..........................................8,000....................................10,236
...........60,000.......................4,050..........................................9,600....................................13,650
...........70,000.......................5,998........................................11,200....................................17,198
...........80,000.......................8,404........................................12,800....................................21,204
...........90,000.....................10,820........................................14,400....................................25,220
.........100,000.....................13,330........................................16,000....................................29,330
.........200,000.....................45,572........................................32,000....................................77,572

Please use the above numbers as reference only, as every taxpayer's situation is unique and offers various opportunities for tax savings and right tax strategy.
Contact us for no-obligation evaluation and free-of-charge initial consultation.


Important notice(1): The information above may reflect a subjective interpretation by the author(s), who, by no means may accept any responsibility or liability whatsoever for the results of proper or improper use of the above information, whole or in part, it as well is explicitly stated that whatever information provided by authors, may not suit specific purpose of specific reader, and it alone may not be relied upon to produce decision. In each individual case professional advice must be obtained.

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