How to compensate yourself from your business?
Compensation is an essential aspect of running a business and ensuring financial stability. In my community for entrepreneurs, The Beehive, this is one of the most common question that arises. As a business owner, it's important to understand the various methods of compensating yourself. In this blog post I will provide insights into the various compensation methods available and their pros and cons.
Owner Compensation Method #1: Salary
A salary is a fixed amount of money that a business owner pays themselves (and often their employees) as regular compensation for their work within the business. It is typically structured through a formal payroll system, with various taxes and deductions withheld from each pay cheque and remitted to the government. Receiving a salary provides the advantage of a consistent and predictable income, making it easier to manage personal finances.
Some considerations for salary compensation in Canada include:
Personal Income Tax: You will have personal income tax deducted off of each of your pay cheques at the applicable tax rates.
Business Income Tax: Salary payments (to yourself and your employees) are deductible as a business expense, reducing your business’ taxable income.
Canada Pension Plan (CPP) contributions: Salary payments require you to make CPP contributions, which provide you with future retirement benefits.
Employment Insurance (EI) premiums: As an employee of your own business, you may choose to pay EI premiums to be eligible for employment insurance benefits.
Salary Pros
Consistent and predictable income income making it easier to manage personal finances.
Paying yourself with salary makes you eligible for certain benefits and deductions.
Having taxes taken off of each pay means you usually prevent a large tax bill at the end of the year.
Salary Cons
Higher payroll costs and administrative burden to run payroll.
If you are the only employee, it might not make sense to undergo formal payroll.
Payroll taxes and deductions must be remitted regularly throughout the year.
Owner Compensation Method #2: Dividends
Dividends are a way that profits are distributed to the shareholders of a corporation. If you are an owner of a corporation, you can compensate yourself with dividends. Dividends are typically taxed at a lower rate than salaries, and they offer income splitting opportunities, allowing business owners to allocate dividends to family members who may also be shareholders in the corporation. However, it's important to note that dividends can only be distributed to shareholders in a corporation and are not applicable to sole proprietors.
Some key considerations to compensating yourself with dividends:
Eligibility: Dividends can only be distributed to shareholders of a corporation. If your business is structured as a corporation, you must be a shareholder to receive dividends.
Tax Advantages: Dividends are typically subject to lower tax rates than salaries. This can result in potential tax savings compared to taking a higher salary.
Income Splitting: If other family members are shareholders, dividends can be allocated to them, allowing for income splitting and potential tax savings.
Profitability: Dividends can only be distributed if the corporation has sufficient retained earnings or accumulated profits.
Dividend Pros
Tax advantages: typically lower tax rates compared to salaries.
Tax deferral: don’t pay income taxes until tax time rather than throughout the year.
Potential for income splitting if family members are shareholders of the corporation.
Dividend Cons
Requires sufficient profits, as dividends are distributed from retained earnings/accumulated profits.
Limited to shareholders of Corporations and are therefore not applicable to sole proprietors.
Owners Compensation Method #3: Owner's Draw
An owner's draw refers to taking money out of the business for personal use. Unlike a salary, this method of compensation does not involve a formal payroll structure or withholding taxes. Business owners simply withdraw funds from their business accounts as needed. This method provides flexibility and easy access to business funds.
Since there are no taxes withheld from each payment, it is important to consider the future tax implications, since taxes will need to be paid when your tax return is filed. In order to properly plan for tax time, I would recommended consulting with your accountant to understand the tax implications in your particular financial circumstances.
Owner’s Draws don’t have to be cash withdrawals from the business. Oftentimes, they come about by purchasing something for yourself with your business bank account or credit card. These expenditures should be coded to your ‘Owners Draw’ account to recognize that this will have to be considered personal income in the future.
Some key considerations to compensating yourself with owners draws:
Tax Reporting: An owner's draw does not involve a formal payroll system. Instead, the amount withdrawn is reported as personal income on your personal tax return.
Personal Liability: If you are a sole proprietor, you are personally liable for the business's debts. It's essential to carefully manage your business finances to avoid any negative impact on your personal financial situation.
Tax Implications: Owner's draw is not subject to tax withholding, so it's important to set aside funds for income tax obligations in the future.
Owners Draw Pros
Flexible access to business funds.
No payroll taxes or administration.
Defers personal income taxes until tax time.
Owners Draw Cons
Defers personal income taxes until tax time. (This can be good or bad, depending on your financial management skills)
Lack of formality which can make it difficult to track and account for the funds drawn from the business.
Limited ‘Proof of Income’: When applying for personal loans or mortgages, having a consistent and documented income source like salary or dividends can be beneficial.
Owners Compensation Method #4: Bonuses
A bonus is a performance-based compensation method that business owners may use to reward themselves for achieving specific business goals or milestones. These can take various forms, such as year-end bonuses, performance-based incentives, or profit-sharing arrangements. Bonuses and incentives are especially useful in motivating the employees of a company and to help align their interests with the success of the business. However, it's important to note that these compensation methods are subject to payroll taxes and compliance with applicable employment standards.
Some key considerations to compensating yourself with Bonuses:
Performance-Based: Bonuses and incentives are typically tied to achieving specific business goals, milestones, or key performance indicators.
Payroll Taxes: Bonuses are subject to payroll taxes, including income tax withholding, CPP contributions, and potentially EI premiums.
Reasonable Compensation: When determining bonuses, it's important to ensure they are reasonable and justifiable based on the business's profitability and performance.
Bonus Pros
Rewards performance.
Motivates both employees and business owners.
Ties income to company performance, ensuring you don’t overburden you business with high salaries.
Bonus Cons
Subject to payroll taxes and deductions, similar to salary.
Taxed at a rate usually higher than regular salary. (When taxes filed, excess gets reimbursed)
Performance-based requirements.
None of this is ‘one-size-fits-all’
There are many factors that help you determine which is the best way to compensate yourself from your business. It is common that business owners use a combination of these compensation methods, perhaps by paying themselves a salary and also receiving dividends.
For someone who craves stability and predictability (often lacking in the entrepreneurial space), a set salary might make sense. Someone who has few financial obligations and does not need to withdraw money from the business regularly might opt instead to declare dividends a few times a year. There is no “right way” or “wrong way” - you will need to determine that for yourself.
If you found this information helpful, I strongly encourage you to check out The Beehive and join my community of entrepreneurs to get your future business finance questions answered!