When a corporation is profitable, the directors of the corporation decide what to do with the profits.
Options include reinvesting the profits into the business, paying down the corporation’s debt, paying bonuses to employees, or paying dividends to shareholders. This article is about the latter—paying out dividends.
This article is specifically directed towards small, privately owned businesses in Canada.
Most corporations in Canada are small, privately owned businesses. Usually, the person running the business wears many hats in the business: they are often an employee, a shareholder, a director, and an officer of the corporation.
What are dividends?
Dividends are payments made by a company in order to distribute excess cash to its shareholders. A corporation’s Board of Directors determines the distribution of dividends. When dividends are paid out, a corporation is responsible for ensuring that the CRA receives the required information on those dividends. Having a corporate accountant is extremely valuable to ensure that your company is compliant with the CRA.
How are dividend payments distributed?
There are several different ways that dividends may be distributed among shareholders. Often, a corporation’s articles will have information or rules and restrictions regarding dividend payments. For example, suppose a corporation has Class A voting shares and Class B non-voting shares. In that case, it may also have a “Priority as to Dividends” rule, where the holders of the Class B non-voting shares receive dividends in priority to the holders of the Class A voting shares. Therefore, it is important that if you are a company shareholder, you understand the rights and restrictions around the shares you own.
When dividends are distributed, they are often distributed as regular payments (by cash or bank transfer), or they may be paid out as additional shares or other property. Many companies distribute dividends to shareholders on a quarterly basis; however, this can vary greatly from one company to another.
When can you pay dividends?
You can pay out dividends at any time. And you can pay out dividends multiple times a year. For example, in some small companies, it is not uncommon for shareholders to take out regular draws from the company for personal use and to qualify them as dividends, loan repayments, or employment income after the fact when the tax returns are being prepared for that fiscal year. (While this approach is not uncommon, it’s not ideal from a tax or legal perspective and should be discussed with your accountant.)
But you need to be sure that there is enough cash, or liquidity, in the business before you pay out dividends. There is a “test” that needs to be met before a corporation can pay out dividends. Here is the test from the Canada Business Corporations Act (and the test is similar for most other jurisdictions in Canada):
A corporation shall not declare or pay a dividend if there are reasonable grounds for believing that
(a) the corporation is, or would after the payment be, unable to pay its liabilities as they become due; or
(b) the realizable value of the corporation’s assets would thereby be less than the aggregate of its liabilities and stated capital of all classes.
In short, You can’t pay out a dividend if it would leave your company unable to pay out its creditors.
In most small companies, you will have a good idea of those numbers, but double-checking with your accountant is always safest.
Why are dividends useful?
Dividends are a tax-efficient way to get money out of a corporation and into the hands of shareholders. This is especially true in the case of smaller corporations where the shareholders are also actively involved in the operation of the company as employees. Dividends are taxed at a lower rate than employment income, so the more that the owner/operator can receive dividends (as opposed to employment income), the less tax that the owner/operator will be required to pay.
For owners of slightly larger companies that are looking to exit, dividend rates are beneficial for signalling the value of a corporation to potential purchasers. They show that the business is profitable. Dividends also help promote shareholder confidence in the company’s ability to grow and sustain itself over time, which is especially important if there are non-active shareholders.
If you are an owner of a small business, it may feel tedious to update your corporation’s Minute Book and keep the appropriate records of your dividend payments. Still, it is extremely important to make a record of the payments, which is required by law. These records are especially important if the CRA ever audits you—in the absence of dividend resolutions, they might treat payments as employment income rather than dividend income. Also, if you ever want to sell your company, the potential buyers will want to know detailed information about your company’s history and stability—and a lot of that can be seen by how much you’ve been able to pay yourself in dividends.
Are there any disadvantages to dividends?
As a small business owner, receiving Dividends minimizes your ability to:
- Contribute to an RRSP
- Receive other personal income tax deductions
There can be some disadvantages to receiving dividends. This often depends on how much money your company is bringing in—if it’s not bringing in enough, then dividends may not be the right choice for you. As we’ve mentioned above (not to sound like a broken record), hiring a corporate accountant is really helpful to allow you to decide how you would like to get paid by your corporation—as there are also advantages to receiving a salary that you will want to discuss, as well as decisions based around saving for retirement that you’ll want to consider. Every corporation is unique, and accountants can help you decide the best approach for your company.
We hope this article gives you a better understanding of dividend payments. As every corporation is unique, we recommend that you seek professional advice to help you decide the best strategy for your corporation when it comes to receiving income.
At Tobuso, we can help you organize the records of your dividend payments into your digital Minute Book. We offer a robust platform for managing and sharing your corporate records—secure and reserved for those you trust. Sign up today!
