Salary or dividends: Which form of compensation is better?

A salary is compensation paid for the work you do for your company. Because it’s treated as a business deduction, it reduces your company’s taxable earnings. As a business owner, however, you must pay personal taxes on this income. 

Dividends represent net profits distributed to shareholders after corporate taxes have been paid. Unlike a salary, dividend income doesn’t qualify as a business deduction to reduce your company’s taxable income.

In many situations, paying yourself a salary can be advantageous, even if it means being subject to a personal tax rate. Here are the main benefits:

Individuals are usually taxed at lower rates than corporations. If your business’s tax rate is high, paying yourself a salary allows you to deduct it from your active business income, reducing your overall tax bill. 

Generally, when income exceeds the business limit, distributing it as a salary becomes more advantageous. While this threshold varies based on several factors, it is typically around $500,000. 

While tax considerations are important, they shouldn’t be the sole criteria when deciding between a salary and dividends. Your compensation strategy can also impact your business’s financial situation, future financing needs, and long-term growth goals.

By paying yourself a salary, you also generate RRSP contribution room based on your employment income, allowing you to benefit from a tax deduction. The younger you are, the more attractive this option is, since your contributions will grow tax-deferred for a longer period. 

A salary also allows you to contribute to government pension plans like the Canada Pension Plan (CPP). Amounts withheld as source deductions are paid back to you in retirement as an indexed pension. 

This is advantageous if:  

• You are younger and haven’t contributed much to these plans. 
• You have mostly received dividends over your career. 

This is less advantageous if:  

• You have already contributed to these plans, and new contributions do not significantly increase your pension. 

In certain situations, paying yourself dividend income allows you to pay less tax. For example, when: 

• Your business income is below the business limit. 
• You have maximized your contributions to public pension plans. 
• You are retired or about to retire. 
• Your staff accumulates more than 5,500 paid hours per year, preventing your business from qualifying for the SBD (in Quebec only). 

Even if paying dividends seems more tax advantageous, you must also evaluate the impact on your business’s finances. Large payouts could reduce its retained earnings and limit your flexibility to fund growth or meet future needs.

To distinguish between the different types of dividends, you need to understand a major tax principle: integration. Its goal is for business income to be taxed at similar overall rates. Regardless of the path money takes to reach your pocket, tax authorities treat it roughly the same way. 

For this reason, different types of dividends exist – the more a business’s profits are taxed, the less shareholders will pay in personal taxes on those dividends. And vice versa. 

Here are the main types of dividends: 

These dividends generally come from business income below the business limit that was taxed at a lower rate. 

To compensate for this lower corporate tax rate, these dividends are identified as non-eligible or ordinary. Once distributed to shareholders, they’ll be taxed at a higher tax bracket.

Conversely, eligible dividends come from business income that exceeds the business limit threshold and was consequently taxed at a higher rate. They’re therefore taxed at a lower rate for shareholders due to the dividend tax credit. 

The general rate income pool (GRIP) is a tax account that tracks business income taxed at the general rate. It determines what portion of profits can be distributed to shareholders as eligible dividends without triggering tax penalties.   

These dividends come from earnings generated by the business that aren’t taxable. They are therefore tax free for the shareholders who receive them. 

Like GRIP, the capital dividend account (CDA) is a tax account used to track items such as the tax-free portion of capital gains. The higher the balance, the more tax-free dividends can be paid to shareholders. 

Rather than being paid in cash, an eligible, non-eligible or tax-free capital dividend can also take the form of shares or property owned by the business. That said, these forms of dividends are much less common. 

Before making your decision, consider your business’s financial needs. Large dividend payouts can reduce your company's retained earnings and equity. This can impact the key indicators banks use to grant you financing: your liquidity, working capital as well as debt-to-equity and fixed-charge coverage ratios, which measure your repayment capacity. If you plan to finance your company’s growth, make an acquisition, buy equipment or improve your working capital, it’s better to retain a larger share of the capital.

Nothing requires you to choose just one of these compensation methods. For example, you could pay yourself a business salary to generate RRSP contribution room and contribute to public pension plans, and supplement with dividends to lighten your overall tax bill. 

Several factors can determine the best compensation model for you, including your age, personal needs and goals, and your business's financial situation. The choice between paying yourself a salary or dividends – or exploring income splitting strategies – can have a tax impact, but that isn’t the only factor that should guide your decision. You must also consider your business’s long-term growth and financing strategies. 

Because these payment methods are subject to specific regulations, it’s recommended to seek professional advice from tax and accounting specialists to make the right decision. If you need help finding the right balance, we’re here to assist you.