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Paying Yourself As a Small Business Owner—The Complete Guide

By January 16, 2020 No Comments

Canadian small business owners run their business with one main goal: to grow their revenue. Growing the bottom line is important, but so is the notion of paying yourself. In this guide, we will explore the methods that small business owners can pay themselves—each with its own advantages and disadvantages. 

In Kashoo’s Complete Guide, we will explore: 

  1. Methods for paying yourself (and its advantages/disadvantages) 
  2. Business structure considerations 
  3. How to record money in and money out in Kashoo: an overview
  4. Conclusion: What have we learned?

1. Methods for paying yourself

Paying yourself comes with a variety of options; however, it is reliant on your business and personal needs as well as your current situation (i.e. whether you are the head of the household). The three methods that small business owners can use to pay themselves salaries and bonuses, dividends, or shareholder loans. 

Salary and Bonuses

Paying yourself a salary requires setting up a payroll account with the Canada Revenue Agency (CRA). Don’t fret—it’s a simple phone call to the CRA business line so that they can help you set up an account. The payroll account you receive will have the same number as your corporation. The only difference is that the account will contact an “RP” rather than an “RC” that is listed at the end of your corporate business number. In this scenario, 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.

Advantages of this method

Paying yourself a salary gives you a legally recognizable personal income. Unlike paying yourself in dividends (detailed in the next section), receiving a salary—even as a business owner—lets you save for retirement through both involuntary Canadian Pension Plan (CPP) and voluntary Registered Retirement Savings Plan (RRSP) contributions. This is even more so if you personally rely on forced retirement savings, as a salary helps ensure you don’t miss an upcoming contribution.

Disadvantages of this method

Paying yourself a salary is taxed at a higher rate than dividends. Asides from 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 up of things like payroll, taxes, fixed costs, and overheads.

If you want to take the guesswork out of your salary, accounting software can help solve that hurdle. Kashoo for instance helps you figure out how much you can really afford to pay yourself. We do this by: 

  • Keeping track of all expenses
  • Calculating profit rather than revenue
  • Discovering areas to capitalize on tax deductions

Dividends

Dividends are paid out of a corporation’s profits. These distributions of profit 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.

Advantages of this method

Dividends are a much more flexible option compared to a salary or bonus. Paying yourself using this method provide 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.

Disadvantages of this method

If you are leaning towards selecting dividends, you likely already have some sort of external pension and retirement capabilities set. Since dividends don’t trigger CPP contributions or count towards RRSP contribution limits, you are 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 loan applications. 

Shareholder Loan

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 an 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.

Advantages of this method

A key and unique advantage of paying yourself via a shareholder loan account are 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 31, 2021. This is a fantastic strategy to borrowing money from your business to pay or a personal purchase such as your home. However, make sure to meet the repayment deadline to avoid irreversible implications. 

Disadvantages of this method

Since there is no administrative work related to shareholder loans—the biggest takeaway is to avoid withdrawing more than what you initially contributed to the business. Remember, you have one fiscal year to pay off your shareholder loan, otherwise, all of it will count towards your income.

2. Business structure considerations

A small business owner must consider several factors when they first form their business. How their business is organized all have different sets of rules regarding how their owners, members, or shareholders are paid and taxed. 

Sole Proprietorships

The majority of small businesses are sole proprietorships, which simply means an unincorporated business owned by one person. Typically, the proprietorship files taxes as part of the owner’s personal taxes—meaning that the business profits count towards the owner’s income. Payments for this business structure are done through a draw.

Partnerships

Much like sole proprietorships, partners in a partnership are taxed on the full profits of a business. These profits are subsequently split based on the partnership agreement. Payments for this business structure are done through a guaranteed payment.

Let’s say a partnership shows a $100,000 profit and each partner owns 50% of the business. Both partners will then be responsible for the taxes on $50,000. If, however, the partnership is split 70/30, then Partner 1 will be liable for taxes on $70,000 and Partner 2 will be liable for taxes on $30,000.

S and C Corporations

Partners in a partnership or the owner in an LLC can vote to decide if the business is taxed as an S corporation (more commonly known as S corp). If so, an S corp can pass the tax liability on to its partners or members based on an ownership percentage. The business itself will then have no tax liability. In this business structure, S corp shareholders receive payment both in the form of a regular salary (which is included in payroll expenses on the Profit and Loss Statement) and also through distributions (which appears on the balance sheet). S corp shareholders are typically also employees of the business. Payments for these business structures are done through a salary.

3. How to record money in and money out in Kashoo: an overview

Now that we have an understanding of what all this means, let’s educate ourselves on how we record the money that we take into and out of our business—right from Kashoo!

Within Kashoo, there is an account called “contributed capital” that tracks funds that you move from your personal account to 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, when an owner needs to take money out of the business, it is called an owner’s draw.

Here’s how you can do it.

Recording an Owner Investment (example)

To record an owner investment of $100,000 on January 1, 2020:

  1. Go to the Journal Entries page and Enter Transfer:
  2. Date: January 1, 2020
  3. Amount: 100,000
  4. Withdraw From: Contributed Capital
  5. Deposit Into: Bank Account (this is your business bank account)
  6. Click on Add Transfer

Set Up an Owner’s Draw Account

To withdraw money out of the business, you as an owner will want to set up an Owner’s Draw account.

To set up an Owner’s Draw account:

  1. Go to the Accounts page and in the top section, enter:
  2. Name: Owner’s Draw
  3. Type: Equity
  4. Then click on Add Account

Recording an Owner’s Draw (example)

Here’s how you can record an owner’s draw of $1,000 on January 31, 2020:

  1. Go to the Journal Entries page and Enter Transfer:
  2. Date: January 31, 2020
  3. Amount: 1000
  4. Withdraw From: Bank Account (this is your business bank account)
  5. Deposit Into: Owner’s Draw
  6. Click on Add Transfer

See here for additional details on how you can record these transactions as other types of business structures.

4. 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 went over the three methods that 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), and finally, how you can record these types of transactions in Kashoo’s accounting software.

If you are considering accounting software to help make paying yourself a simpler processtry Kashoo’s free 14-day trial today to let us help guide you.

Stay on top of your bookkeeping with Kashoo