If you’re a solopreneur, freelancer, independent contractor, or any other type of small business owner, you will have to consider paying yourself from your business at some point! Whether you’re looking to pay yourself via monthly compensation or an annual salary, it’s important you understand the rules and regulations so you’re able to properly file your taxes at the end of the year! In this guide, we’ll explore the methods that small business owners can pay themselves—each with its own advantages and disadvantages.
- Methods for paying yourself (and its advantages/disadvantages)
- Business structure considerations
- How to record money in and money out in TrulySmall™ Accounting: an overview
- Conclusion: What have we learned?
The tips in this article are mainly focused on small businesses that have incorporated their business. If you’re a sole proprietor or in a partnership, the methods for remitting and reporting your income will be different than the steps listed below.
Paying Yourself As a Small Business Owner
Methods for Paying Yourself
When you’re considering paying yourself, there are actually a ton of methods you can go about it. However, your decision should be reliant on your business and personal needs as well as your current situation (ie. whether you’re the head of the household). Generally, there are 3 methods you can choose from when deciding how you want to pay yourself. A salary or bonus, a dividend, or through shareholder loans.
Salary and Bonuses
Paying yourself a salary is the most consistent way to get paid out but it does require you to do some setup work. This will require setting up a payroll account with the Canada Revenue Agency (CRA). This process is pretty simple, you can do it online or by calling into the CRA business line and they can help with setting up the account.
The payroll account you create will have the same number as your corporation. The only difference is the account will contact an ‘RP’ rather than an ‘RC’ that is listed at the end of your corporation business number. If this is the method you choose to pay yourself, the salary will be a deduction that will reduce your corporate net income; however, your salary will be taxed separately on your personal tax return.
Paying yourself a salary gives you a legally recognizable personal income. Unlike paying yourself in dividends (which we will discuss in the next section), receiving a salary gives you the opportunity to tap into other financial benefits such as contributing to an involuntary Canadian Pension Plan (CPP) and the voluntary Registered Retirement Savings Plan (RRSP). It will also be the proof of consistent income that you need for applying for credit cards, loans, and other borrowing methods you may need for whatever reason.
When you pay yourself a salary, your income is taxed at a higher rate than dividends. Besides that, salary payments also comes with further complications like making sure that you are paying yourself out of your profits and not your revenue. There is a clear difference between the two which are made of things like payroll, taxes, fixed costs, and overheads.
If you want to take the guesswork out of your salary, accounting software like TrulySmall™ Accounting can help! These tools can help you figure out how much you can really afford to pay yourself by:
- keeping track of all expenses
- calculating profit rather than revenue
- discovering areas to capitalize on tax deductions.
Similar to a salary or a bonus, dividends are paid out of a corporation’s profits. These distributions of profits are calculated based on each shareholder’s ownership in the corporation. To pay a dividend, you must set up an RZ account with the CRA. Keep in mind when paying yourself dividends, you are required to issue a T5 slip, which should appear in your personal tax return.
Dividends are a much more flexible option compared to a salary or bonus. Paying yourself using this method provides more room for cash flow since it avoids mandatory retirement contribution requirements. From an administrative perspective, it’s less of a headache because you do not need to make CPP contributions or remit source deductions on a monthly basis.
The downside of choosing dividends as your payout method is that you will have to set up some sort of external pension and retirement fund to make sure you’re still saving towards your retirement. Since dividends don’t trigger CPP contributions or count towards RRSP contribution limits, you will be retiring through non-traditional means as opposed to a salary.
Additionally, the major downside to this method is difficulty applying for non-business-related credit. A mortgage is a good example since dividends don’t count towards your salary calculations on a loan application.
A shareholder loan is any funds that you have contributed to the corporation. It also represents funds that you have withdrawn from the corporation which is done tax-free. As an example, let’s say that the owner withdraws money from its corporation. If that withdrawal was never assigned as a salary or dividend, it automatically creates a loan from the corporation to the shareholder.
The reason these withdrawals are tax-free is because of the above-noted contributions that are made with “after-tax” dollars.
The main unique advantage of paying yourself via a shareholder loan account is the mandated timelines available to pay back the loan without incurring any interest or penalties. For this method, you have 365 days to pay back your loan from the end of your fiscal year-end. If your year-end is December 31, 2020, for instance, and you borrow your money from your corporation on January 1, 2020, you are not obligated to repay it until December 31st, 2021.
This makes a fantastic strategy to borrowing money from your business to pay for a personal purchase such as your home. However, make sure to meet the repayment deadline to avoid irreversible implications.
Since there is no administrative work related to shareholder loans—the biggest takeaway is withdrawing more than what you initially contributed to the business. Remember, you have one fiscal year to pay off your shareholder loan, otherwise, it will all count towards your income!
How to Decide How Much To Pay Yourself
Unlike when you’re an employee at a company, the income of a small business owner is often erratic, with many peaks and valleys. Although your income becomes slightly less consistent, many still choose to start a business on their own for all the other benefits that come with being a business owner!
When thinking about how much to pay yourself, the most important consideration is your business structure. As a corporation, it’s could be helpful to consult an accountant or tax specialist when deciding which of the above methods you should go with and their implications to your actual tax remittance.
As mentioned above, it’s also important to consider your business’ overall financial wellness before you decide how much to pay yourself out. Make sure that all of your overheads, expenses and other costs are covered before you make any salary or dividend decisions. You should also prioritize setting aside money to pay the quarterly or annual taxes for your business as well as these fees are commonly forgotten and can leave you strapped for cash come tax season.
How To Record Money In and Money Out in TrulySmall™ Accounting: An Overview
Now that we’ve gotten the methods out of the way, it’s time to chat about how we actually record the money going in and out of your business. The easiest way BY FAR is by using an accounting solution like TrulySmall™ Accounting.
TrulySmall™ Accounting allows you to connect your bank accounts and credit cards so that all of your transactions automatically gets imported into TrulySmall™ automatically. Within your ‘Accounts’, there’s an account called ‘Contributed Capital’ that helps to track funds that you move from your personal account into your business bank account. Whether it’s a deposit into the business bank account or used to pay for a business expense, any personal funds entering your business will come from the contributed bank account and is called an “owner investment”.
Vice versa, whenever an owner needs to take money out of the business, it’s called an “owner’s draw”.
Whenever you deposit or withdraw money from your business bank account, those transactions will automatically get pulled into TrulySmall™ Accounting. Once they’re in, you can view them on your ‘Inbox’ page, edit them, and categorize them as a ‘Transfer’.
If you would like to manually enter a transfer, just head to your ‘Transactions’ page, hit the ‘Add +’ button, and select ‘Transfer’.
Conclusion: What have we learned?
Determining how you should pay yourself is only the tip of the “financial” iceberg to consider as you run your small business. In this complete guide, we covered 3 methods you can use to pay yourself as a small business owner, how your business structure plays a role in how you get paid (and are taxed), as well as how you can record these types of transactions within TrulySmall™ Accounting!
If you’re ready to save time within your accounting process, then try TrulySmall™ Accounting today and see just how easy it is to track any and all transactions having to do with your business!