By Haroon Khan, CPA, CA (Canada), CPA (USA)
Many of our clients approach us while actively running their sole proprietor/partnership businesses or managing their individual investments. They often ponder whether it is best to establish a corporation to conduct their business or continue operating as sole proprietors or in partnerships.
In this blog post, we will delve into the advantages and disadvantages of opting for a corporation over a sole proprietorship or partnership when it comes to carrying out business activities.
Before we proceed, I’d like to emphasize that if you decide to incorporate your proprietorship and/or partnership after reading this blog it’s crucial to consult either us or your tax advisors. The process of converting a business into a corporation is not as straightforward as one might think. Specific elections need to be filed with the Canada Revenue Agency (CRA) for this transaction to be tax free. This election is commonly referred to as section 85(1) rollover. Failure to adhere properly to these rules can lead to tax consequences accompanied by significant penalties and interest.
Decision on Incorporation
There are factors, both tax-related and non-tax related, that influence the consideration of incorporating a business or an investment portfolio. The primary tax planning matters worth considering include;
- Tax Deferral
Imagine being in a situation where you have an option regarding how you manage your earned income. Option one, you can take it home, and pay high tax on it. Two, you can keep it within your corporation and benefit from lower tax rates. The second option gives you an advantage called “tax deferral.”
Intrigued? Here’s an example: In Ontario a corporation’s tax rate for business income can be low as 12.2% (consisting of 9% federal and 3.2% provincial). Now consider that the highest personal tax rate for individuals in Ontario is 53.53%.
Here’s where the magic happens. If you’re in that high tax bracket and decide to leave your income within a corporation, you could enjoy a tax deferral of around 41.33% (53.53% less 12.2%). That means you don’t have to hand over that money to the tax authorities. Please note, there are certain conditions to maximum tax-deferral party. Your corporation needs to be a Canadian Controlled Private Corporation (CCPC) and it should be eligible for a business deduction which will help maximize these advantages. It’s like giving yourself a head start in managing your finances.
2. Income Splitting
Before the Tax on Split Income (TOSI) era, many people chose to incorporate their businesses for the sake of income splitting. The idea of income splitting arose to distribute dividend income via valid sources among family members instead of keeping it in one person’s hands. The aim of this strategy was to lessen the tax burden for a family, and it made sense because of Canada’s tax system, where higher incomes are taxed at higher rates i.e., the progressive tax rate system.
Let’s consider an individual earning $200,000 personally, they would face higher taxes compared to a couple each earning $100,000. Income splitting provided an advantageous tax treatment. However, with the introduction of TOSI the possibility of income splitting was limited.
Nonetheless, some tax planning strategies can still help navigate the TOSI rules and optimize your tax situation. It becomes crucial in this context to seek advice to make decisions and take full advantage of available tax planning opportunities.
- Recharacterization of Income
Early retirement is a goal cherished by many individuals in today’s world. Imagine this scenario; you’ve made the decision to retire at the age of 50. You’ve carefully built up an investment portfolio that generates an annual return to support your retirement dreams. If you were receiving this income as an individual, it would typically be classified as investment income.
Now let’s introduce the concept of the Registered Retirement Savings Plan (RRSP) into the equation. RRSPs give you the advantage to defer tax on your contributions until your retirement. Income Splitting opportunities can be availed through RRSP’s contribution as well. Unfortunately, directly earning your investment income won’t provide you with RRSP room.
Here’s where things get interesting. You could earn that investment income within a corporation. Then pay yourself a salary instead. By doing this you have the power to transform your income from investment earnings into employment income, effectively changing its character. This opens up the opportunity for generating RRSP contribution room that can be used in the future.
This is one example of how recharacterization can serve as a financial tool. There are reasons why one might consider recharacterization, such as optimizing deductions, for childcare expenses and more.
4. Absolute Tax Savings
Along with corporations, comes an effective tax-saving strategy. Here is an example to illustrate this point. Imagine you’ve earned $300,000 individually and your annual expenses require you to use $150,000. If you earn the $300,000 individually in one year you would face a higher tax burden.
Now consider an approach. Suppose you earn $300,000, within a corporation and decide to withdraw $150,000 from your corporation over two years. This strategy spreads out your income over two years resulting in a lower tax rate during this time. As a result, you can achieve tax savings.
In essence having a corporation not only provides an advantage of deferring taxes but also offers the practical benefit of reducing your overall tax liability, bringing money in your pocket.
5. Capital Gain Deduction
Incorporating your business can present an opportunity: the Lifetime Capital Gains Deduction (LCGE), for shareholders of qualifying business corporations (QSBCs). In 2023 this deduction has the potential to reach an amount of $971,190.
Let’s observe an example: Imagine you started a business, with an investment of $100. Through your hard work over the years, it has grown into a business worth $1,000,000. If you were the owner, the capital gains tax on this increase in value would be quite substantial at $999,900 (Proceeds of $1,000,000 less ACB of $100). Considering that, capital gains have an income inclusion rate of 50% making your taxable income $499,950. Since you are already in Ontario’s tax bracket at 53.53% this would result in a tax bill of $267,623 ($499,950 x 53.53%).
Here is where it gets interesting: by incorporating your business and engaging in tax planning to claim the QSBC deduction you can potentially avoid most of this tax burden. In the scenario, as a QSBC shareholder, your capital gain of $999,900 could be offset by the LCGE (Lifetime Capital Gains Exemption) amounting to $971,190. As a result, your taxable capital gain would reduce significantly to $14,355. This led to a much lower tax liability of only $7,684. The savings? An impressive $259,939!
There is more good news! You can extend this LCGE benefit to family members as well. For instance, if you have five family members involved in the business venture with you, that could potentially mean an exemption amounting to a total of $4,855,950 ($971,190 x 5). We have successfully implemented this strategy for clients who have sold businesses worth $10 million and managed to avoid paying any taxes all thanks to planning.
6. Estate Freeze
Congratulations on the accomplishment of your business! Now as you consider passing it on to the generation you will want to ensure that the transition is not smooth but also beneficial in terms of taxes. This is where estate planning becomes crucial and if you are a shareholder in a corporation, it becomes a possibility for you.
Estate planning serves purposes, but two ones are highly significant:
- Preserving Future Growth: One of the objectives of estate planning is to enable you to pass on the future growth of your business to the next generation. By structuring your business within a corporation, you can lay the groundwork for a transfer of ownership. This implies that as your business continues flourishing your successors can enjoy its benefits without facing tax liabilities.
- When it comes to estate planning you can also consider how it can help you make the most of the Capital Gains Deduction we mentioned earlier. You can ensure that this valuable deduction is fully utilized by incorporating strategies into your estate plan. This will not only reduce the tax burden on your estate but also provide a significant financial advantage for your beneficiaries.
In essence, estate planning is not just about transferring your business to the next generation, it’s about doing so in a tax efficient manner and maximizing the benefits of the Capital Gains Deduction. By leveraging the tools within a corporation framework you can secure the business of your future by safeguarding its well-being for your beneficiaries.
7. Limited Liability
Additionally incorporating a business offers more than just tax benefits. It also provides non-tax advantages. One key advantage is limited liability protection for shareholders, unlike proprietors or partnership shareholders of a corporation have limited liability and are only responsible for amounts equal to their investment in shares of the corporation. This means their personal assets are protected from business-related liabilities. This aspect of liability protection can be a factor, in deciding whether to incorporate, especially when there are substantial risks of financial losses involved.
In situations, the protection of assets might be of more importance, than other considerations, such as taxes. It’s worth noting that there are circumstances where directors of a company can be personally responsible for certain corporate debts. For example, according to tax laws, directors can be held liable for Goods and Services Tax (GST) and source deductions.
So even though incorporating a business provides protection against business liabilities there are exceptions where directors still bear responsibility for the financial obligations of the company.
8. Continuation of Your Legacy
Your business can truly serve as your everlasting legacy. How you structure it has an impact on its ongoing existence. When you operate as a proprietor your business is closely tied to your identity. However, it may cease to exist after your passing.
On the other hand, when you incorporate your business it becomes a legal entity. This means that even after you pass away the corporation can continue to exist and operate. This continuity is one of the advantages of incorporating a business. It allows for the longevity of your business, offering opportunities for your heirs to carry on your legacy or make decisions such as selling the business or passing it down to subsequent generations.
Deciding Against Business Incorporation
While there are certainly benefits, to incorporating a business it’s also crucial to consider the downsides. Let’s explore the drawbacks of opting for business incorporation.
1. Additional Administrative Expenses: Establishing a business comes with commitments, including government incorporation fees and ongoing filing expenses. There might also be legal charges associated with document preparation and meeting election filing requirements, especially when transferring assets to the corporation. Moreover, running a corporation involves governmental filing obligations and administrative responsibilities compared to operating as an individual. This includes maintaining records of shareholders’ and director’s meetings in a Minute Book and submitting a Corporate Summary to the Corporate Registry.
2. Challenges in Dissolution: Closing a business can be more complex if it is structured as a corporation than an individual setup. When an individual decides to discontinue their business or sell assets they generally receive after-tax cash without hassle. Whereas, when a corporation chooses to sell its assets or cease operations obtaining after tax cash can become more intricate. Dissolving a corporation often requires measures, like documentation of processes and making submissions to tax authorities.
Key Takeaway:
In conclusion, determining whether to incorporate your business or stick with your structure is a decision that carries significant consequences. As we’ve covered in this blog post there are tax and non-tax factors to consider. Incorporation offers benefits, like deferring taxes opportunities for income splitting recharacterizing income, substantial tax savings and the Capital Gain Deduction which can provide advantages.
Furthermore, incorporation also brings tax benefits such as limited liability protection and the potential for your business to maintain its legacy. However, it’s important to acknowledge the potential downsides too such as expenses and the complexities involved in dissolving a corporation.
Before making a choice it’s crucial to seek advice from a tax advisor or financial professional who can evaluate your situation and offer guidance. Additionally, if you do decide to incorporate, be mindful of the elections and filings required by tax authorities (like the section 85(1) rollover in Canada) to ensure a transition, with optimal tax efficiency.
Ultimately selecting between incorporation and maintaining your business structure should align with your term financial objectives, like the nature of your business operations and your willingness to handle administrative responsibilities.
By making informed choices you can set the groundwork for a financially optimized future, for your company.
