Once you operate through a corporation, the question of how to pay yourself recurs every year. You are both a shareholder and a potential employee of the corporation. The combination of salary and dividends you draw in a given year affects your personal tax bill, your RRSP contribution room, your CPP entitlement, and whether the corporate deduction holds up on review.
This article covers what drives the decision and what CRA looks at when assessing whether shareholder compensation is reasonable.
How incorporated contractors pay themselves
Two primary options exist once income is earned inside the corporation.
Salary is paid to you as an employee of your corporation. The corporation deducts the salary as a business expense. You report it as employment income on your T1. A T4 slip is issued. CPP contributions apply, and the salary generates RRSP contribution room.
Dividends are distributions from after-tax corporate profit. The corporation does not deduct them. They are taxed on your personal return under the gross-up and dividend tax credit system, which often results in a different effective tax rate than employment income. No CPP contributions apply. No RRSP contribution room is generated.
Most incorporated contractors use a combination, but the mix changes year to year. The proportion depends on the corporation’s income, your personal income from other sources, your RRSP room, your CPP goals, your province of residence, and how much income you want to leave inside the corporation. The mix also affects how much income remains in the corporation and whether corporate tax deferral is being used.
What reasonable means
Section 67 of the Income Tax Act disallows deductions that are not reasonable in the circumstances. Applied to shareholder compensation, this means the salary a corporation deducts should reflect the value of services actually performed.
CRA’s reference point is what the corporation would pay an arm’s length employee for the same work. A salary calibrated to tax minimization rather than the value of services is the clearest basis for a challenge. An incorporated IT contractor drawing a salary far above what the role would command in the market, without documentation supporting the level, has a weaker position than one who can point to a rationale.
In practice, where the shareholder is actively generating the corporation’s income, CRA generally accepts a wider range of compensation levels than would apply in a purely arm’s length employment situation. The concern is not the number itself but whether it can be explained by reference to the services performed.
The reasonableness question typically does not arise in routine processing, but becomes relevant in audits of closely held corporations, particularly where compensation levels are unusual relative to corporate income or services performed.
What salary creates that dividends do not
RRSP contribution room. The RRSP contribution limit is 18% of the prior year’s earned income. Salary counts as earned income. Dividends do not. An incorporated contractor drawing only dividends accumulates no RRSP room in those years. This gap compounds over a career and is not recoverable once the filing years have passed.
CPP contributions and retirement entitlement. As a shareholder-employee, you pay both the employee and employer portions of CPP contributions on salary. That doubles the immediate cash cost, but it also builds your CPP retirement benefit entitlement. Dividends contribute nothing toward CPP.
Neither outcome is automatically better. The choice between RRSP room, CPP entitlement, and a lower current-year tax bill is a planning decision, not a one-way answer.
The case for a written compensation plan
A compensation plan documents the rationale for the salary level: the role performed, hours committed, and a market reference for similar services. It does not need to be elaborate, but it should exist before the corporation’s T2 return is filed for the year the salary was paid.
Without documentation, the position rests on the numbers alone. If the deduction becomes a question in a CRA review, something more than a year-end transfer is needed to support it.
The plan also forces the decision to happen deliberately. Salary levels set at year-end, retroactively, based on whatever the corporate balance sheet shows, are harder to defend than compensation agreed earlier in the year with a documented rationale.
Timing matters
Salary paid in a given fiscal year must be paid or properly recorded as a payable before the corporation’s year-end to be deductible in that year. For many small corporations with a December 31 year-end, this creates a tight window in late fall or early winter where the compensation mix needs to be determined.
Waiting until the T2 is being prepared to decide the salary level is common. It is not ideal. The later the decision is made, the less documentation typically exists to support it.
Planning earlier in the fiscal year, even if the final number adjusts as income becomes clearer, produces a cleaner file and a more defensible position.
What to bring to a CPA conversation
A CPA reviewing shareholder compensation will typically want to know:
- the corporation’s net income before any owner salary
- the contractor’s other personal income sources
- current RRSP contribution room (on the most recent Notice of Assessment)
- whether CPP coverage and retirement entitlement are a priority
- whether any dividends were paid during the year
- the corporation’s projected income for the coming year
The T2 corporate return and T1 personal return are planned together. Decisions made on one affect the other, and the optimal combination cannot be determined by looking at either return in isolation.
For contractors who are not yet incorporated, the decision to incorporate should be reviewed before structuring any compensation plan. For contractors already incorporated, reasonable salary is part of annual planning, not a one-time setup step.