Business and Operations
Giving yourself a salary
By Treena Hein
The benefits of taking a regular salary and the risks of not doing so
By Treena Hein
Many restaurant owners – maybe you’re one of them – don’t give themselves any kind of regular pay and instead just take money out of the store account as needed.
While this is technically legal, it is rather poor business management for a variety of reasons, whether it’s a corporation or a sole proprietor business arrangement.
Before we look at exactly why it’s a risky practice and what you should do instead, let’s first look at what people do as an alternative to taking a salary.
“Oftentimes, small business owners take a monthly draw, which is effectively a loan which they have to repay by their company year-end,” says Bob Sutter, a commercial credit banking specialist with 40 years’ experience. “This means they have to declare a salary or dividends at the end of the year, resulting in a big tax liability. Also, sometimes they borrow to repay the debt over the year-end point, and this does defer the tax payment if they don’t get caught.” All this, he says, is just plain bad tax planning. He advises that it’s always best to pay as you earn.
Small business owners often also charge personal expenses (cellphone, vehicle expenses and so on) to the business on an ongoing basis instead of taking a salary and, to the extent they can get away with it, Sutter says it does result in reduced personal income, which in turn reduces personal income tax. It’s a situation of being constantly reimbursed instead of drawing a salary. However, Sutter advises being careful to keep good records and to ensure expenses are completely legitimate, or “reimbursements” may be treated as personal income in future Canada Revenue Agency (CRA) audits.
Another scenario where owners don’t take a salary is where, if they needed to lend money to the business some time in the past, they can repay themselves in lieu of salary. No tax is therefore owed to the government. “This scenario, however, tends to reduce the credit worthiness of the business by reducing capitalization,” Sutter explains. “Financial institutions tend to look mainly at T4s to measure personal income and company-paid expenses, and loan repayments don’t show up there.”
CRA media relations officer Zoltan Csepregi says that a business owner may draw funds from their business account for various reasons, including salary, loans, dividend payments or to help pay personal expenditures, but all payments have to be reported. Failure to report payments may be flagged by the CRA for review or audit. “Personal or living expenses cannot be deducted against business or personal taxes payable,” he adds. “An individual would have their personal tax returns opened to add the amount to their taxable incomes, as a benefit from the company. A taxpayer could face penalties on their corporate returns for the amount expensed and on their personal returns for the benefits received but not declared.”
Putting aside the risk of audits and their potentially ugly consequences, the practice of not taking a salary can have a strong negative effect on one’s ability to get personal credit such as a mortgage. In assessing an application for a large loan, lenders must examine an applicant’s net income after expenses from a “Notice of Assessment” – in most cases, examining at least two years of net income and calculating an average. Obviously, if your net income is low, you may be refused, as an applicant’s “capacity to pay” is one of the most important factors in determining risk for a lender. So, to ensure success when trying to borrow to buy a home or even a car – which most of us need to do – it’s best to make sure lenders see a suitable amount of personal income so they can be reasonably sure the applicant can
make the payments.
Beyond the personal credit risks, we asked Alex Shteriev (a managing director and partner at Beacon Corporation in Toronto) how the practice of not taking a salary can impact your business. “It affects the amount of credit the business can receive, as current financial obligations large or small are taken into account when determining the ability of the business to repay any loans,” he says. Sutter echoes the sentiment. “Overall,” he says, “credit ability of small businesses is tied to the personal worth and income of the owner. Taking a salary shows commercial bankers a truer and less complicated picture of how the business is doing for business valuation and business borrowing purposes.” Not taking a salary does not affect selling your business, however, according to Shteriev, as all personal expenses and salaries are added back to obtain the true ability of the business to generate cash flow.
PAYING YOURSELF CORRECTLY
In terms of the right way to pay yourself, Shteriev says there are multiple correct ways of doing it. “One is not better than the other, but rather better for your situation,” he explains. “In a corporation, a salary can be paid if more cash is needed on hand. Personal expenses can be run through the business, and if they are classified as non-taxable benefits, they will not be added to personal income and remain on the corporate tax return. Dividends can be paid at year-end to distribute wealth to various individuals to take advantage of the dividend tax credits, which reduces taxes payable, as well as lower individual tax brackets.”
Sutter says the most reliable method of paying oneself in a sole proprietor situation is to pay yourself a salary and pay-source deductions (income tax, Canadian Pension Plan and so on) like everyone else, normally on a quarterly basis. This method offers several advantages, in Sutter’s view. “You don’t get behind with the CRA and there are no nasty surprises at tax time,” he says. “As we’ve discussed, you also have a solid record of personal income when attempting to borrow.” Sutter says that in addition, if it happens that the business made more than enough to pay that salary, this can be shown as elective income if necessary if the lender will recognize it. Elective means you could have taken more salary than you did but chose to leave it in the business.”
There are other options, but they are harder to keep track of, may risk unexpected outcomes at tax time and can make it tougher to demonstrate the success of the business and the personal income of the business owner.
“You can pay yourself periodic draws by borrowing from the business or, as mentioned, repaying funds previously lent to the business, or pay yourself dividends from business profits,”
Sutter says. “You can also pay yourself rent if you own the business property or pay yourself management fees or bonuses.”
RISKS AND REWARDS
Rewards of paying yourself a salary
- helps ensure you don’t get behind on tax payments
- provides a solid record of personal income
Risks of not paying yourself a salary
- negative effect on your ability to get credit such as a personal loan
- negative effect on the amount of credit your business can receive