Tax Guide for Small Business Owners
All memorandums are for informational purposes only and do not constitute legal advice. Additionally, the memorandum does not create or intend to create a solicitor-client relationship between the reader and the initio Technology and Innovation Law Clinic
Tax Guide for Small Business Owners
As a Founder and Small Business Owner, what is the best way to pay myself?
As your company begins or continues to generate revenue and profits, it is important to understand the different ways to pay yourself. The goal of this memorandum is to inform founders of new and growing incorporated companies of the ways to pay themselves from their business. There are different ways of doing this, and the best way to pay oneself will always depend on a number of factors. Always speak to an accountant or other qualified professional to determine the best way to pay yourself out of your company based on your own individual circumstances.
Salary & Bonuses
Small business owners often pay themselves a salary (otherwise known as a wage) and/or bonus as an employee of the company. The salary and bonus paid to you by the company will be a deduction from your company’s net income, allowing your company to reduce its total tax liabilities. As an employee, you will have to pay federal and provincial personal income taxes on the salary amount paid to you. To pay yourself a salary as an employee of your company, you must set up a payroll account (“RP” designation) with the Canada Revenue Agency (CRA). Contact the CRA business line to do this – it is a simple process. For example, you may choose to pay yourself $4,000 per month in salary in 2020, totaling $48,000 for the year. Your company may then deduct the salary paid to you as an expense, reducing its tax bill. For 2020, you would pay personal income tax on $48,000.
Advantages:
Lower corporate taxes: Employee wages can be deducted from your company’s taxable and net income.
RRSP benefit: Registered Retirement Savings Plan contributions are based on the prior year’s income. Paying yourself a salary will give you more room to make future contributions, which are, in turn, tax deductible from your personal income.
Receiving provable income: Having a salary and income will give you provable income, an advantage when obtaining lines of credit, credit, loans, and mortgages.
CPP contributions: A salary will provide you with employer contributions towards your Canada Pension Plan.
Tax deferrals: You will be able to defer future corporate taxes by paying yourself a bonus, so long as the bonus is paid within 180 days of the end of your fiscal year.
Disadvantages:
Personal income taxes: You will have to claim a personal income and pay tax on it.
CPP expenses: Employer contributions to an employee’s Canada Pension Plan must be remitted to the CRA. This requires additional paperwork and a loss in your company’s short-term cash flow. Depending on your company’s size, you may also have to make Employment Insurance and other contributions. You will also have CPP payments deducted from your personal wages.
Visit the CRA website here to view payroll deductions tables for federal and provincial income taxes, employment insurance, and CPP.
Speak to an accountant or other qualified professional to determine the best way to pay yourself out of your company based on your own individual circumstances.
Dividends
Another way to pay yourself out of your company is to pay yourself dividends (as a shareholder) out of the company’s profits. Dividends are paid out to shareholders based on a given class of shares on a pro rata basis. For example, two shareholders each hold 50 shares of the company’s 100 outstanding shares. The company pays out a dividend of $500 per share. Each shareholder would receive $25,000 (or 50 shares times $500 per share). When dividends are paid, the company must also issue a T5 tax slip. The shareholders would include their dividend amount as taxable personal income. To pay yourself dividends as a shareholder of your company, you must set up an information return account (“RZ” designation) with the CRA. Contact the CRA business line to do this – it is a simple process.
Under federal legislation, your company cannot pay out dividends unless it meets a solvency test (which tests your company’s fiscal position). Your company will not be able to pay out dividends if (1) doing so would make the company unable to pay its liabilities and where (2) your company’s assets are less than its total liabilities plus its total share capital. For more information on solvency tests, please visit this free online resource.
Be careful with dividends: tax changes introduced in 2017 complicate issues around issuing yourself dividends. Please speak to an accountant about your eligibility to properly and efficiently use dividends.
Advantages:
Fewer contribution costs: Paying dividends does not require companies to make CPP or other contributions on a monthly basis.
Less administrative headache: Because there are no monthly contribution costs, dividends require less record keeping and administration.
Disadvantages:
Dividends are not tax deductible: The company may not deduct dividends paid to shareholders from its net income, meaning it would be taxable income.
Personal income taxes: You will also have to claim dividends as personal income and pay tax on them.
Less provable income: Dividends are not considered “earned income” and therefore do not contribute to RRSP contribution limits or to proving income for the purposes of obtaining credit.
No CPP contributions: Employers needn’t contribute to an employee’s CPP.
Sources included on the downloadable version