Incorporation and Investment
Getting incorporated can be one of the most powerful tools doctors, business
owners or consultants can use to reduce their tax bite, but it isn’t always
applicable for everyone who can do so.
Incorporation may not benefit you if:
• You are paying little to no personal taxes
• You recently started your business and have little to no revenue.
• You are spending every dollar you make — or close to it.
• Your business and personal expenses are close to your company’s revenue
You may benefit from incorporating if:
• You feel like you are paying way too much in personal taxes
• You are saving at least $25,000 a year
• The company you own is paying you a salary of $100,000 or more
• You will be funding part of your children’s post-secondary education
• You will be able to sell your business in the future for a significant amount of money
• You have a whole life insurance policy
• You are investing significant sums into your RRSPs every year
• You are paying down debt aggressively
• You are considering a sabbatical in the future
• Your company’s revenue can be fairly variable from year to year
Advantages of Incorporating
Limited Liability
The main advantage to incorporating is the limited liability of the incorporated company. Unlike the sole proprietorship, where the business owner assumes all the liability of the company, when a business becomes incorporated, an individual shareholder’s liability is limited to the amount they have invested in the company.1
If you’re a sole proprietor, your personal assets, such as your house and car, can be seized to pay the debts of your business; as a shareholder in a corporation, you can’t be held responsible for the debts of the corporation unless you’ve given a personal guarantee.2
Corporations also have the same rights as individuals; meaning they can own property, carry on business, incur liabilities, and sue or be sued.
Corporations Carry On
Another advantage of incorporating is continuance. Unlike a sole proprietorship, a corporation has an unlimited lifespan—it will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes. This makes selling a corporation more straightforward than attempting to sell a sole proprietorship.
Optimizing Your Income and Taxes
If you incorporate your small business, you can determine when and how you receive income from the business, which is a real tax advantage. Instead of taking a salary from the business when the business receives income, being incorporated allows you to take your income at a time when you’ll pay less in tax. You can also receive income from an incorporated business in the form of dividends rather than salary, which will lower your tax bill.
Potential Tax Deferral
Becoming incorporated gives you tax deferral potential if you are a higher income earner. Business tax rates are much lower than personal tax rates, so if your individual marginal tax rate is high and you don’t need the funds for personal use, you can elect to leave money in the business and take it out at a later date when your personal tax rate is lower.
For example, say your Canadian business had $300,000 in earnings after expenses for the year:
- If you took out the entire $300,000 as salary in 2019 (and had no deductions), you would pay $78,296 in personal taxes, a marginal tax rate of 29.6%.
- If you took out $200,000 as salary in 2019, you would pay $45,711 in personal taxes, a marginal tax rate of 22.9%.
- On the $100,000 left in the company, the general corporate tax would be 15% for a total of $15,000. So, your total tax in this scenario would be $45,711 in personal tax plus $15,000 in corporate tax, or $60,711—a savings of $17,585 in taxes compared to taking out the entire $300,000 as salary.
The Small Business Tax Deduction
If you incorporate your business, it may qualify for the federal small business deduction (SBD). The SBD is calculated at the rate of 11.5% on the first $500,000 of taxable income, which may reduce your net corporate business tax to a much lower tax rate than you would receive on your personal income.
Disadvantages of Incorporating
Another Tax Return
When you incorporate your small business, you’ll have to file two tax returns each year, one for your personal income and one for the corporation. This, of course, will mean increased accounting fees.
Increased Paperwork
There is a lot more paperwork involved in maintaining a corporation than a sole proprietorship or partnership. Corporations, for example, must maintain a minute book containing the corporate bylaws and minutes from corporate meetings. Other corporate documents that must be kept up to date at all times include the register of directors, the share register, and the transfer register.
No Personal Tax Credits
It’s possible that being incorporated may actually be a tax disadvantage for your business. Corporations are not eligible for personal tax credits. Every dollar a corporation earned is taxed. As a sole proprietor, you may be able to claim tax credits a corporation could not.
Less Tax Flexibility
A corporation doesn’t have the same flexibility in handling business losses that a sole proprietorship or a partnership does. As a sole proprietor, if your business experiences operating losses, you could use the loss to reduce other types of personal income in the year the losses occur. In a corporation, however, these losses can only be carried forward or back to reduce the corporation’s income from other years.
Liability May Not Be as Limited as You Think
The prime advantage of incorporating—limited liability—may be undercut by personal guarantees or credit agreements. A corporation’s much-vaunted limited liability is irrelevant if no one will give the corporation credit.
When a corporation has what lending institutions consider to be insufficient assets to secure debt financing, they often insist on personal guarantees from the business owner(s). So, although technically the corporation has limited liability, the owner still ends up being personally liable if the corporation can’t meet its repayment obligations.
Registering a Corporation Is Expensive
Corporations are more expensive to set up than other business structures. A corporation is a more complex legal structure than a sole proprietorship or partnership, so it naturally carries more costs to set up. Fees for incorporating a small business federally or within a province range in the hundreds of dollars.
Closing a Corporation Is More Difficult
Closing a corporation requires passing a corporate resolution to dissolve the corporation, winding up payroll accounts, and sending a copy of the certificate of dissolution to your provincial authorities (or the Canada Revenue Agency). You will also need to file your final tax returns for the corporation.
How to Get Money Out of Your Corporation
If you have a small business corporation, you may be receiving income in the form of salary or dividends. However, there are other ways of getting money out of a private corporation that may be more tax efficient. Here is a list of the seven most common ways to get money out of your corporation.
1. Salary
If you are an owner/manager, you can pay yourself a salary. The salary is taxable in your hands at your marginal tax rate, but it is deductible by the corporation. This may not seem to make sense: Why would you chose to pay tax at the higher personal rates rather than the small business rates? You should pay yourself enough to generate the maximum RRSP contribution room. Even if you don’t intend to use the RRSP room now, this may be beneficial in later years if you want to make RRSP contributions or if the business wants to establish an individual pension plan or IPP.
In addition, you will also pay into the Canada Pension Plan that allows you to draw on those benefits at retirement.
2. Bonus
If your corporations’ income is more than $500,000 or if your company’s earnings are volatile you might want to pay yourself a bonus instead of a salary. The bonus is treated the same as employment income for tax purposes but provides more flexibility in payment.
The bonus may also be used to bring the corporations income below the $500,000 small business deduction limit to maximize the use of the lower tax rates on corporate income.
3. Dividends
Dividends are paid from the corporations after tax-income. For most Canadian small business corporations, the dividends paid are ineligible dividends and subject to a 25% gross up and a 13.33% tax credit on the grossed up amount. This gross-up and tax credit system is designed to eliminate double taxation.
4. Payments on Loans From Shareholders
You can invest in a corporation through investments in shares or by lending the company (or any combination). If you lent money to the corporation, the repayment of the principal amount is tax-free.
5. Capital Dividends
Canada only taxes 1/2 of capital gains. When a corporation realizes capital gains, the non-taxable half of the gain is credited to a notional Capital Dividend Account. The balance of the capital dividend account may be paid to the shareholders entirely tax-free.
6. Repayment of Capital
The amount you originally invested in your corporation is credited to an account called paid up capital. The balance of this account can be repaid at any time tax-free. Keep in mind, that doing so may have other tax consequences later on, so speak with your accountant.
7. Loans To Shareholders
General Tax Rule For Shareholder Loans
The general rule is that your shareholder loan must be repaid within one year from the end of the corporations’ tax year then the loan will not be taxed in your hands.
You may be able to have the loan outstanding for longer 12 months depending on when the loan was taken out and the corporation’s year end. However, caution must be taken as missing the repayment deadline can have some unwelcome tax consequences.
3 Exceptions To The Shareholder Loan Rules
There are three general exceptions to shareholder loan provisions under the income Tax Act.
1. One Year Rule – As outlined above,if the loan is repaid by the shareholder within the year after the end of the corporations’ tax year, the loan is not included in income.
However, the loan cannot be a series of loans and repayments. On the other hand, if a current loan account is maintained in the corporation for a shareholder during a tax year and the year-end balance is repaid from salary or declared dividends the CRA will generally not consider these transactions as a series of loans or repayments.
2. The Lenders Rule – If the corporations’ business is lending money or the debt is from the normal business activities then the loan is not considered a shareholder loan, provided standard arrangements are made for repayment and are maintained.
3. Principal Residence Rule – If the shareholder is also an employee and a loan is advanced to purchase a principal residence, new shares in the corporation, or a vehicle to be used for business purposes then the loan is not considered income In addition, the loan must be advanced due to employment and not due to shares held and standard arrangements are made for repayment are made and maintained.
Repaying A Shareholder Loan
When the loan is repaid that was previously included in income for tax purposes, it may be deducted from income of the year of payment.
Before you take a loan, be sure to discuss the matter with your accountant. If the loan is not properly structured, the costs of the loan could be substantial.
A Little Planning goes a long way.
Incorporating a business offers benefits that help soften the blow, those advantages are tax deferral (retaining funds inside the corporation and paying tax at the personal level later) and income splitting (paying dividends to family members who are in lower personal tax brackets).
While tax rates vary by province, they can take a serious toll on a business’s bottom line. As of this year, for example, the marginal tax rate in Ontario for salary or other income higher than $220,000 is a staggering 53.5 per cent – a 4-percentage-point increase over 2015 rates. For non-eligible dividends, the rate is 45.3 per cent, more than 5 points higher than last year.
Think twice about withdrawing funds from corporations if it means pushing your personal income above the $220,000 mark.
If you have a mortgage or a line of credit held at the personal level, which carries a low rate of interest given today’s low-rate environment, It might be more beneficial to avoid accelerating the paydown of debt through corporate withdrawals and, instead, carry the debt, and retain the funds in the corporation.
The funds can be retained in the business and invested and withdrawn at a later date – retirement – when the taxpayer is likely in a lower tax bracket.
If the taxpayer is fortunate to have RRSPs or non-registered capital held outside of the corporation, these funds can be drawn on to augment cash-flow needs rather than corporate funds.
If you are a business owner and earning income in your corporation and you don’t need it to live on, it’s best to leave it in the business.
Either reinvest it in the business or, if the business doesn’t need the capital, invest it in a portfolio of securities inside the business, or alternatively in something like a corporate-owned life insurance policy.
This approach is especially logical for small-business owners, who continue to benefit from a low tax rate in their corporations because of the small-business deduction. Even though Mr. Trudeau has vowed to tax the rich, this deduction was spared in the most recent Liberal budget.
You pay a very low rate of tax on the first $500,000 of active income of 10.5 per cent the rest of the money can sit in there forever until you need it, and you don’t pay tax until later on, until you withdraw it as a dividend.
How Do You Get It Out of your Corporation:
One tax-savvy approach is the purchase of a corporate-owned life-insurance policy. When the business owner dies, money is paid out through the capital dividend account (CDA). That’s usually tax-free to beneficiaries.
Regulatory changes took effect in 2017. that lowered the amount of the tax-free portion that can come from an insurance policy and flow to beneficiaries through that CDA.
Another approach for business owners to consider, is setting up a personal pension plan (PPP). When you make contributions to a PPP, it’s a contribution from the company and it’s deductible.
Essentially, if the business owner is taking a salary, then they’re able to contribute more to a pension than they would an RRSP, so it gives you additional deductions, and the deductions are at the business level so you can save tax.