Wages vs. Dividends - Part 3

The Meeting

We are continuing the discussion I had with my client, Mary, about factors shareholders should consider when deciding to pay themselves wages or dividends. The last article discussed issues around cash flow and the effect on your contribution room for RRSP investments.

Need Any Personal Financing?

Before starting your business, you might have needed to borrow money for a new car or finance your home. The bank would have looked at your annual wages and assessed your ability to repay the loan based on a percentage of your employment income.

Now that you are self-employed, through your own company, you could be paying yourself exclusively through dividends.

Guess what? Most bankers don't get it.

They can relate to a regular recurring wage because they are familiar with them.

Sometimes investments pay dividends, and sometimes they don't. Dividends are an allocation of profits. A company can't pay a dividend if it doesn't make money. A banker believes wages are predictable, but dividends are inconsistent and discretionary. If you're only paying yourself dividends, you could have a bigger challenge getting a personal loan.

Say two companies have the same $100,000 profit before paying their shareholder. One could pay it all out as wages. The other could pay its corporate taxes and then pay a dividend of what is left. The initial funds are equal, but the shareholder receiving only dividends could have a tough time getting their next loan approved.

Wages tend to beat out dividends with respect to this issue.

Shareholder's Liability

I can't leave this issue without mentioning the very real issue of shareholder liability.

The banks are not the only ones who think of wages very differently than dividends. Canada Revenue Agency (CRA) and the courts do too.

For the small business owner who controls the company, the choice between wages and dividends is often based on what is easy or simple. Dividends are always simpler.

Remember, wages are paid for work done (employment income), and dividends are a return on your investment in the company.

Suppose you take out more money than the company can afford as dividends. You will likely fall into arrears on your corporate taxes owing.

When CRA calls to collect, they determine what you have taken for dividends in the previous years. The payment of dividends is an allocation of corporate profits. If you paid yourself those profits instead of using the money to pay the CRA, then the CRA, with court approval, will be able to seize your personal assets to recover the corporate debt owing.

Since wages are paid for work done, the CRA would have a more challenging time coming after your wages for unpaid corporate taxes.

They would have no direct line to your personal assets.

Note: The CRA does have the ability to collect personally from a director of the corporation for any unpaid GST or payroll remittances. Those are considered trust accounts. Any director who does not ensure those funds are properly managed and remitted to CRA can be liable for not fulfilling their director responsibilities.

What's Best?

It depends! On you, your spending habits, how much money you need at home, and the amount and consistency of your company's cash flow.

My new business owner, Mary, had concerns about her ability to commit to paying a regular wage. After all, this was a new venture. She was also concerned about getting behind in her taxes and didn't want to give the CRA any reason to audit her. My suggestion was as follows:

Start by figuring out what your absolute minimum need is at home. Then set a budget at home based on this.

Estimate what you expect the company to be able to pay for wages and benefits (CPP) for your salary.

If your home budget needs are less than what the company can pay, take a monthly salary large enough to cover those needs.

If your home budget needs are greater than what the company can pay, there is a problem, at least until the company starts generating more income.

The Rest of the Story

There was a problem in Mary's case, so we worked together to figure out what Mary thought she could commit to for her monthly salary. Any extra she took out would be recorded as a drawing in the interim and reported as a dividend at year-end.

When the cash flow improved, she would gradually increase her payroll commitment until it was enough to cover her minimum monthly needs at home.

Mary could track her "extra" drawings throughout the year by posting these amounts to her shareholder loan account in her books. Knowing a tax bill was coming for about 50% of this amount, she agreed to squirrel away a little extra when she had a good month to save for the corresponding additional taxes.

Things seldom go as planned, but the plan had flexibility built in, and she kept in touch so we could advise her in those first critical years of business.

Things were still a little too tight after the first fiscal year. Fortunately, we were able to stagger the initial dividend over a couple of calendar years to defer the taxes. By the second fiscal year, the company was doing better, and she increased her salary to ease the financial pressure on her personal life.

Now, Mary knows the company is generating enough to pay its bills with enough left over so her salary can cover her needs and then some. She still hopes to take home more for her efforts and has plans to move forward. When those unexpected needs arise at home, she takes a dividend and immediately starts saving for the extra taxes.

With a plan in place and corporate and personal taxes covered, her stress is down. If anything unusual comes up, she knows she has an ally she can call on.

Let Us Help You

You and your business are unique. There are no one-size-fits-all answers for us business owners. We have to figure it out for ourselves. That said, you don't have to do it alone.

We've carefully listened to business owners for more than 30 years. We've helped them resolve their issues and lessen their stress as their business ally.

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See Our Summary of Considerations - Wages vs. Dividends