Salary vs. Dividends: The Optimal Compensation Strategy for Professional Corporations

One of the most frequent questions I get asked by professionals – whether they're doctors, lawyers, engineers, or other consultants operating through a professional corporation – is how best to pay themselves. Should it be a salary, dividends, or a combination of both? As a principal at Cerazy Mitchler Corporation, a Chartered Professional Accountants firm in Langley, BC, I can tell you there's no one-size-fits-all answer. The optimal compensation strategy is a critical component of corporate tax planning and depends heavily on your unique circumstances.

Understanding the nuances between salary and dividends is key to maximizing your after-tax income and achieving your financial goals. Let's break down what your professional corporation should consider.

Understanding the Basics: Salary

A salary is essentially what an employee (including you, as the owner-manager) earns for services rendered to the corporation.

Pros of Salary:

• RRSP Contribution Room: Paying a salary generates earned income, which creates contribution room for your Registered Retirement Savings Plan (RRSP). This allows you to defer tax on income saved for retirement.

• CPP Contributions: Both the employee and employer portions of Canada Pension Plan (CPP) contributions are made on salary. While it's an expense, it builds your future retirement benefits.

• Expense to Corporation: Salary is a tax-deductible expense for your professional corporation, reducing its taxable income.

• Clear Pay Structure: Provides a predictable and steady income stream.

• Child Care Expense Deduction: For those with children, earned income from salary can be used to support the claim for the Child Care Expense deduction.

Cons of Salary:

• Immediate Personal Tax: Salary is taxed at your personal marginal tax rates as it's earned, meaning you pay income tax immediately.

• CPP Contributions: While a pro for future benefits, the employer portion of CPP is an additional expense for the corporation that isn't incurred with dividends.

Understanding the Basics: Dividends

Dividends are distributions of after-tax profits from the corporation to its shareholders.

Pros of Dividends:

• No CPP Contributions: Neither the corporation nor the shareholder pays CPP contributions on dividends. This can result in significant savings, especially for owner-managers who may already be contributing through other employment or who are near retirement.

• Lower Corporate Tax on Distributed Income: Due to Canada's "integration" principle (which aims to ensure that income taxed in a corporation and then paid out to a shareholder is taxed at roughly the same rate as if it were earned directly by the individual), non-eligible dividends generally face a lower combined corporate and personal tax rate compared to salary at higher income levels.

• Tax Deferral Opportunity: Income remaining in the corporation is taxed at the corporate small business rate (much lower than personal rates). This allows for significant tax deferral on retained earnings if not all profit is distributed.

Cons of Dividends:

• No RRSP Contribution Room: Dividends do not create earned income, so they do not generate RRSP contribution room.

• Not a Corporate Expense: Dividends are paid from after-tax corporate profits, meaning they are not a tax-deductible expense for the corporation.

• No EI or Other Benefits: Dividends do not qualify you for Employment Insurance (EI) benefits.

Specific Considerations for Your Professional Corporation

To determine the optimal mix, your professional corporation should consider these factors:

1. Your Personal Income Needs: How much do you need for living expenses? A predictable salary provides stability.

2. Other Sources of Income: Do you have income from other employment or investments? This impacts your personal marginal tax rate.

3. RRSP Contribution Goals: Are you maximizing your RRSP contributions? Salary is essential for building contribution room.

4. CPP Needs: Are you relying on CPP for retirement, or do you have other pension plans? For many owner-managers, avoiding the employer portion of CPP on dividends can be a big win.

5. Corporate Cash Flow: How much profit does your corporation consistently generate? Can it sustain a regular salary or variable dividends?

6. Future Growth & Investment Plans: Do you plan to leave significant profits in the corporation for future investment, expansion, or a large purchase (e.g., commercial real estate)? Retaining earnings within the corporation is much more tax-efficient at the low small business tax rate.

7. Child Care Expense Deduction: If you claim child care expenses, you need sufficient earned income (typically salary) to maximize this deduction.

8. Age and Retirement Horizon: For those nearing retirement, avoiding CPP contributions on dividends can be appealing. For younger professionals, building CPP benefits might be more important.

The Role of Your CPA

Navigating the salary vs. dividend decision requires a detailed financial analysis of your individual and corporate tax situation. This is where a knowledgeable accountant near me comes in. Your CPA can:

• Perform a Tax Pro-Forma Analysis: We can model various salary/dividend combinations to project your total combined corporate and personal tax liability, helping you visualize the after-tax impact.

• Develop a Long-Term Compensation Strategy: Beyond just the current year, we help you plan for future income needs, retirement goals, and corporate growth.

• Ensure Compliance: Properly documenting dividend declarations (through Directors' Resolutions) and issuing correct T4 or T5 slips is crucial for CRA compliance.

Conclusion: It Really Does Depend

In conclusion, there is no universal "optimal" compensation strategy for professional corporations. Every professional's scenario is different, and it depends on a multitude of factors – your age, family situation, personal financial goals, the profitability of your corporation, and your appetite for immediate vs. deferred tax.

The best strategy is a dynamic one, requiring ongoing review and adjustment with your CPA. Don't leave money on the table or risk CRA scrutiny by making assumptions. Consult with a qualified professional to craft a compensation strategy that truly works for you and your professional corporation.