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Corporations - Benefits &
Drawbacks
The decision to incorporate
can be based on many factors, but the income tax advantages for
small business corporations usually ranks as the top one.
If you are a Canadian resident
and you own a corporation , it is probably a "Canadian Controlled
Private Corporation" or CCPC, eligible for a low rate of tax on
the first $400,000 of active business income (it must be business
income, not passive investment income).
There is therefore a large
potential tax saving by the use of a CCPC. If you earned a profit
of $200,000 in a sole proprietorship, you would pay @ $90,000 in
personal tax, whereas if $200,000 was earned in a corporation in
Ontario, only about $45,000 in corporate tax would be due.
The important thing to
remember is that there is basically no benefit if you need to
withdraw all the funds from the corporation to live on. That is
because once you withdraw the funds (by a dividend), you will be
taxed on the dividend. The tax system is designed to make the
combined taxes paid by the corporation and you personally equal to
what a sole proprietor would have paid without a corporation. This
works quite efficiently and is the reason for dividends being
"grossed-up" by 25% and the existence of the dividend tax credit
(it is not designed just to confuse us as one might be inclined to
believe!).
If you incorporate and your
company makes more than $400,000 profit in a year, it makes sense
to declare a "bonus" payable to yourself (or any employee for that
matter), to reduce the taxable income in the corporation to
$400,000. That is because the tax system will result in more tax
(double taxation) i.e.. the tax paid by the corporation and the
person (s) involved would exceed that of a person who did not
incorporate (don't get too worried about the details - if you are
in this situation you are business is doing very well!).
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Benefits of Incorporation
-
Tax deferral on first
$400,000 of income - this is the main benefit and has been
discussed above
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Deferral of year end bonus
- if you have not yet chosen a year-end, make it after June 30.
That is because the bonus discussed earlier to bring the
corporation's income down does not have to be actually paid out
at the year end date - any time within 180 days is acceptable.
If, for example you have a September 30 year end, you could
declare a bonus for say $100,000, deduct it as salary expense in
the corporation for the year ended September 30, but not pay it
until January of the next year. You only pay personal tax on the
bonus the next year - a "deferral" of tax for one year.
-
Limited personal liability
- legally you are not normally liable for your corporation's
debts or other liabilities - incorporating your business
significantly reduces your personal exposure to creditors and
liabilities.
-
Capital gains exemption -
the $100,000 "regular" capital gains exemption was eliminated in
1994, but an enhanced $750,000 capital gains exemption for
shares in "qualified small business corporations (QSBC's) still
exists. If you sold your corporation for $750,000 you would pay
NO income tax. This would save a lot of tax money versus someone
who sold the assets of a sole proprietorship or partnership.
Also, remember that at your death you are "deemed" to have
disposed of the shares in your small business - any tax would
otherwise be payable if not for this exemption. NOTE: There are
ways to "freeze" the value of your corporation before any sale
takes place usually, by the use of a holding company. If you
would like more information please call.
-
Income splitting - the use
of a corporation allows more flexibility to allocate income to
lower tax members of your family. In addition to paying your
family members a salary for actual work they do, you can pay
dividends (they obviously have to own shares in the company).
This is very useful if you have children or a spouse with little
or no other income - they can earn up to approximately $30,000 TAX FREE in
the form of a dividend.
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Drawbacks of Incorporation
-
Corporate losses - if the
company incurs a loss, the loss stays in the company - it can be
carried forward for 7 years and be used to offset profit in
future years, but it cannot be used to offset other sources of
personal income. In a sole proprietorship, the business loss
goes on you T1 personal tax return and can reduce you personal
income (and therefore income tax). It therefore often makes
sense, if the start-up phase of your business is expected to be
in a loss position, to start out as a sole proprietorship so
that you can use the losses personally. Once the business
becomes profitable, you can incorporate to take advantage of the
benefits discussed above.
-
Costs of forming and
running - in addition to the costs, there are also higher costs
of administrating a corporation including legal, accounting and
office expenses.
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While shareholders have limited liability, directors of a
corporation are subject to various liabilities. These include
liabilities for unremitted source deductions, unremitted PST and
GST and certain environmental liabilities. Furthermore, passive directors who may not be involved in
running the business may still be subject to certain of these
liabilities. Passive directors should be aware of what the
corporation is doing and should ensure that director's liability
insurance is in place to protect them.
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A potential double taxation trap exists if an active
business earns too much profit. Corporate profits from active business income in excess of
$300,000 per year are taxed at full corporate rates. Integration
of the personal and corporate tax systems does not work at that
rate, resulting in an element of double taxation. Therefore all
income in excess of $200,000 should usually be paid out of the
corporation by way of salary or bonus to avoid this double
taxation trap. If the corporation requires the funds for
operations, the income can be paid to the shareholder and then
loaned back to the corporation. The salary receipt is, however,
taxable to the shareholder.
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A corporation is also subject to strict rules governing the
taxation of shareholder benefits, such as shareholder loans or the
use of a company car. Finally, the transfer of the unincorporated business or
partnership to a corporation will be a taxable transaction unless
a rollover agreement is made and the appropriate election is filed
with Revenue Canada. Provided such an election is made, however,
the transaction can be free of any immediate adverse tax
implications.
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When a proprietorship or a partnership incorporates, it is
generally a good idea to consider any life insurance needs. Upon
the incorporation of a partnership, a shareholders agreement will
normally be entered into, often requiring funding through life
insurance. An incorporated sole proprietorship may not have any
additional life insurance requirements, but in certain
circumstances, such as the entrepreneur being a single parent,
additional life insurance to pay for any deemed capital gains
incurred on the death of the shareholder might be appropriate.
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Summary
In many cases, the combination
of limited personal liability and the lower rate of tax far
outweigh the drawbacks. If you have questions about whether
incorporating is for you just
contact us for more
information. |
