Dividends are a disbursement of the retained earnings of a company to its shareholders. Say the company has been in business two years and both years there was a profit of $10k. At the beginning of the third year, there’s $20k in retained earnings and the company’s management decides to give some of that back to shareholders. Management would declare a dividend of a certain amount per share and would pay out the cash owed to each shareholder based on the number of shares they held.
Dividends can only be paid out to the extent there are retained earnings to disburse. So, in our $20k example, a maximum of $20k in dividends could be paid out.
For small, private companies (not traded on a stock exchange), this is a way for the shareholder(s) to withdraw cash from the company to pay themselves. Dividends have been used traditionally because they’re paid out of after tax income from the corporations perspective (i.e. the corporation has already paid tax on that income), and are usually taxed at a lower rate at the personal level.
So overall, if you added up the tax paid by the corporation and the tax paid by the individual, it would be lower than if the individual had taken a salary, paid tax on that type of income, and the corporation was able to deduct the salary for tax purposes.
As the tax laws have changed, dividends have become less favourable and finding a method to get money out a corporation in a tax effective way has become more nuanced. A good accountant can help you structure the way you pay yourself from your corporation to minimize your tax impacts.