The Dilemma: Dividends vs. Wages
Choosing between Dividends and Wages can be a difficult decision, that really depends on your situation. To help shed light on this topic, we’re sharing a scenario about one particular business and how they made their decision. The good news is our team can help you make the right decision for you.
Sophie & Justin
Meet Sophie. Sophie runs a marketing and PR consultancy business called Brand Incorporated. Sophie’s husband Justin has a good job in management at an oil & gas company. His salary of $125,000 covers the day to day household expenses for the family.
Brand Inc. made $100,000 after expenses last year. Since their family doesn’t require cash from the business for living expenses, Sophie and Justin are looking for advice on how best to minimize their taxes, not only this year, but in the long-term.
The best tax planning tool available
As the owner of Brand Inc, Sophie has the ability to choose the type, timing and amount of her own compensation. This is the best tax planning tool any small business owner has available. Sophie has complete discretion over how much she draws or claims from her corp, here are her best two options:
Option 1: Sophie takes no income
Sophie can choose to take no draws from the corp: she would have no income personally, and would pay no personal tax. Justin can use her basic living allowance and get a $3500 refund. The corporation only pays 12% tax on the $100,000 profit, so she keeps $88,000 in the business bank account.
Option 2: Sophie takes a small draw
If Sophie took an $18,000 dividend and $3500 wage, she would pay no taxes and no CPP.
She could then invest $21,500 personally and invest the remaining $67,000 in the corporation.
Barry & Michelle
Meet Barry & Michelle. Barry was recently laid off from his job. With limited opportunities for a new position, it may take some time for Barry to find a new job. Michelle has her own coaching and public speaking company, called Speak Up Inc. She has been building her business for the past 8 years and the company is now making some good profits.
Michelle is now in the position of sole earner for the family and has questions about whether to take dividends or wages. In 2017, Speak Up Inc. profited $100,000 after expenses and Michelle expects similar results for 2018. Her family needs as much as cash flow from the business as possible to cover living expenses.
Here are her options:
- Dividends: She could take a $3500 wage and an $85,000 dividend. The corp pays almost $12,000 in tax and she pays about $13,000 personally, for a total tax bill of $25,000, leaving $75,000 in her pocket for living expenses. This would strip all the earnings from Speak Up Inc.
- Wages: wages are a business deduction, so Michelle’s business that had $100,000 in profits, would have zero profits after paying Michelle the $100,000 wage. The corporation would pay no tax. The corp would have to pay about $2,500 in CPP. Michelle would also need to pay $2,500 in CPP. In addition to this $5,000 in CPP, Michelle would pay about $23,000 in personal taxes. The remaining cash for Michelle’s household spending is about $72,000.
This is a typical outcome; that wages are a bit more expensive than dividends. Michelle ends up with about $3,000 less cash in her pocket with wages, but she has contributed $5,000 to her Canada Pension Plan. With all dividends, the total tax bill was $25,000. With all wages, the total tax bill is $23,000, after taking out the CPP.
If Michelle invested $9,000 in her RRSP account, she would get back about 33% of this, which would bring down her personal tax bill and her after-tax income up to $75,000. Which is in line with after-tax income from dividends. In this scenario, after her RRSP investment, Michelle would have $66,000 in her pocket. Michelle would have $14,000 invested for retirement, but only have $9,000 less for spending.
However, keep in mind, that when Michelle withdraws these funds from her RRSP account, she will be taxed, and that $3,000 refund is repaid.
Unless she has excess RRSP contribution room, she would not be able to contribute to her RRSP if she chose to take dividends. Dividends are not considered ‘Earned Income’ and do not increase the RRSP contribution limit.
More facts on dividends and wages
- T4 Slips (wages) and T5 Slips (dividends) are due to be filed Feb 28.
- When your corporation earns profits, the cash belongs to the corp, not you. You cannot use those profits for your personal spending without paying tax.
- Your corporation cannot lend you money without tax consequences, and every business owner needs to be familiar with the rules around personal expenses and business expenses.
Taking advantage of tax deferral
The tax benefit to incorporating lies in the ability to defer the personal portion of the tax bill each year. To a certain extent, you have the ability to decide how much tax to pay in any given year. If your corp made a profit, after you had been paid what you need to live on, a common strategy is to leave the extra cash in the corp. By leaving extra profit in the corp, you don’t have to pay tax personally, and small business corps only pay 12% tax.
Let us run the numbers for you
We’re Chartered Professional Accountants (CPA’s) and can give you the exact amount of tax you would pay if you took dividends, and the exact amount of tax & CPP you would pay if you took wages. We can also give you the optimal balance of wages & Dividends.
We have extensive knowledge of the changing tax laws – including ones related to self-employed professionals like yourself. We provide bookkeeping and tax services to small business owners in Okotoks and Calgary, including everything from deductions, write offs, expenses, tax returns, GST filing and more.