This is the first post in our series for incorporated people about salary vs dividends.

Salaries and dividends seem similar from the outside perspective of the person receiving money. However they are conceptually very different from one another from the inside, i.e. from the corporation’s internal accounting perspective.

Begin with the most basic calculation of profit:

Profit = Revenue – Expenses

Salaries are an expense. Dividends are a portion of after-tax profit. The reason that difference matters is because of two key facts:

  • Tax is based on profit, not revenue
  • Expenses reduce profit

Let’s look at an example. Macaulay is a consultant who has incorporated his business, Macomall Consulting Inc. He has an annual revenue of $100,000. Aside from paying himself, his expenses total $5,000 per year.

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

He can pay himself a salary of $95,000, which will bring his profit down to $0 [= $100,000 – 95,000 – 5,000].

Profit = $100,000 – $95,000 – $5,000 = $0

Because corporate tax is based on profit, his corporation will pay no tax. But the corporation will be left with no after-tax profit from which Macauley can pay himself dividends, and he as an individual will pay tax on $95,000 of salary.

On the other hand, he could choose to take no salary, and pay himself via dividends instead. In that case:

Profit = $100,000 – [$0 salary] – $5,000 = $95,000

His corporation has a profit of $95,000 and it will be taxed on that amount. Say the corporate tax rate is 15% or $14,250 [=15% of $95,000]. He’ll be left with $80,750 in profit from which to pay himself a dividend. He will be taxed on that dividend on his personal income tax return.

Salary: lower corporate tax, higher personal tax

Dividends: higher corporate tax, lower personal tax

Those are the conceptual differences between salary and dividends. But what’s the best way to pay less tax overall? Read on in the next post, Salary vs Dividends: How to pay less tax?