This is the second post in our series for incorporated people about salary vs dividends. The first part can be found here.

Taxes are usually the main consideration when a corporation’s owner is deciding whether to pay themselves a salary, dividends, or some combination of the two.

Some people believe that for tax purposes dividends are superior to salary. After all, putting the emphasis on dividends usually means that most tax is paid at the corporate rate (see our previous post), which is lower than the personal income tax rate; and the amount that actually filters down to the recipient of the dividend is taxed at a lower rate than full salary.

But the important thing to remember is that the tax system is not stupid, and that one of its underlying principles is to make sure a person can’t materially change their tax obligations just by setting up a corporation*.

In another post, we introduced Macaulay and his corporation, Macomall Consulting Inc. Macomall has an annual revenue of $100,000 and expenses (aside from what Macaulay pays himself) of $5,000 per year.

His profit = $100,000 – [salary, if any] – $5,000

Salary situation: He can pay himself a salary of $95,000, which will bring his profit down to $0 [= $100,000 – 95,000 – 5,000]. Because corporate tax is based on profit, his corporation will pay no tax. But he as an individual will pay tax on $95,000 of salary.

Dividend situation: Alternatively he can pay himself no salary and take dividends instead. In that case, the corporate profit is $95,000 [$100,000 – $5,000], on which it pays corporate tax, which is lower than personal income tax. Whatever is left after tax is available to him to take as a dividend. That dividend is eligible for a tax credit that results in him paying a lower rate of personal income tax on it, than he would on the same amount of salary.

From a cursory look it appears that the dividend situation is better, because the corporate tax rate is lower than personal, and the personal rate on dividends is lower still. Low rates all around!

A person could be forgiven for missing the key point: if you own the corporation and are also the employee, you’re paying both parts of the tax.

If you own the corporation and are also the employee, you’re paying both parts of the tax.

If Macaulay did the math he’d find that the tax he’d pay on a $95,000 salary wouldn’t be too different from the combined tax – corporate tax on profit plus personal tax on dividends – that would be paid if he let the corporation have the profit and he took the dividend instead.

Put another way, paying yourself dividends instead of tax means splitting the tax between the corporation and the individual. But if you’re both the corporation and the individual, the outcome is more or less the same.

And that’s the point. The tax system is specifically designed so that the tax outcomes are not materially different.

In fact, dividends from Canadian-controlled private corporations like Macomall Consulting Inc. are taxed at a lower rate than salary exactly because it’s understood that some tax has already been paid by the corporation. If you are both the owner of the corporation and the employee, you’re actually paying both parts.

You can tweak the numbers a bit, splitting your income between salary and dividends to find the best possible outcome, and shave that tax bill down a bit. But if you are basically taking the maximum amount from your corporate earnings for yourself – via salary, dividends, or some combination of the two – the differences in terms of tax paid may be immaterial in the end.

But tax isn’t the only consideration. Read the next part of the series to learn more.

* There are, of course, tax-saving techniques that can be implemented via the use of a corporation; it’s just important to be aware that the most straightforward moves often aren’t going to make a big difference, and that’s by design.

This is the second post in our series for incorporated people about salary vs dividends. The first part can be found here. The next part is Salary vs Dividends: Which is better?