To Incorporate or to Not Incorporate?

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To Incorporate or to Not Incorporate?

By Sam Arraj, CPA, CA

Item-5-Photo-A-At least a few times a month, I’ll get an eager self-employed person who will call me up with enthusiasm requesting to incorporate their business – whether it’s an arts business, as a contractor or any other business. I’ll ask them why they want to incorporate and they’ll usually respond that their friend incorporated their business and now they are saving so much tax. This is not necessarily correct, which is why I’m writing this article to provide you with more insight on this subject. This is a complicated subject, so bear with me. I’m not going to cover every angle, as I’m going to try and give you more of a high level understanding.

First and foremost, what is a corporation? A corporation is a legal entity that is separate from its owners (the shareholders). Incorporation can be done at the federal or provincial/territorial level. The key benefit of the corporation is that it provides limited liability; essentially, a shareholder will not be personally liable for the debts, obligations or acts of the corporation. Under a sole proprietorship, the person running the business will be held personally responsible for debts, obligations or acts.

The fact that the corporation provides limited liability to its shareholders is a key advantage of running a business through a corporation, which is why most businesses choose to incorporate. “Then what about the tax savings that friend told me about?”, you ask… technically, the Canadian tax system is based on the principle of Integration, which is based on the premise that an individual earning income through a corporation should be in the same tax position as if that individual had earned the income directly. Essentially, you’ll pay the same tax whether you’re running a business as an individual or through a corporation, so that friend was technically incorrect.

This example shows how integration works: if an individual earned $100 from business, then he would have a tax liability of $30, but if the individual earned $100 through a corporation, then he will pay tax at the corporation level of $15 and the remaining $85 will be paid to the owner through a dividend. The owner will then pay $15 in tax, which results in $15 via the corporation and $15 personally, totaling $30. The mechanics (dividend gross-up and dividend tax credits) of how this is done is complex and beyond the scope of this article.

If there are no tax savings from a corporation, why do so many people make that statement? Well, although there is no tax saving in the long run due to the integration principle, there is an opportunity for tax deferral, as the combined (Ontario and Federal) tax rate for a Canadian Controlled Private Corporation earning income from an active business in Ontario is 15.5%, while the combined personal tax rates range from 20.5% (lowest tax bracket) to 49.53% (highest tax bracket).

You’re probably confused as to why I’m saying that there are no tax savings – only tax deferral through a corporation; but clearly, the corporation tax rates are lower than the personal tax rates. The catch is, in order to pay taxes at the lower rates via the corporation, you will have to leave your business earnings (“cash”) in the corporation. In most cases, the business income earned is required by the owners to pay their personal bills. Since the corporation is a separate legal entity, the owners will be required to withdraw the money through a salary or a dividend, which will be taxed personally; by withdrawing the funds, tax deferral is eliminated.

In addition to tax deferral and limited liability, there are other benefits to having a corporation, which are as follows:

  • The corporation could be used as a tool for tax savings through income splitting with a lower income spouse or family members, but this is a complex subject and should be discussed with your accountant to get a better understanding;
  • It makes it easier to sell the business;
  • It allows for more tools to generate investments;
  • If you have a Qualified Small Business Corporation, you will be entitled to the lifetime capital gains exemption of $800,000 when you sell the business… although, sole proprietors could access this as well. This is another complex area that needs the consultation of an accountant.

There are clearly many advantages to running your business through a corporation, so why is there a significant portion of businesses that are run through a sole proprietorship? There are good reasons for that, which are as follows:

  • Corporations are expensive to set up and to maintain. You’ll need to incur higher costs to incorporate. In addition to your personal tax return, you will need to file a corporate tax return annually, which usually accompanies formal financial statements. Also, you’ll need to engage a lawyer every fiscal year to file annual resolutions and to maintain a minute book. Most lawyers and accountants push for incorporation so they can charge more fees.
  • The corporation is a separate legal entity and one needs to make sure they are not using the funds in the corporation for their personal needs. Technically, the owners would need to get paid through a dividend or salary to use the funds.
  • Tax deferral is achieved only if you don’t need all the funds earned by your business, and in most cases, the individuals would rather keep the funds personally to pay for their personal expenses… therefore, eliminating any tax deferral advantages.
  • If you’re a start-up business, then the business losses that could be used against other personal income are locked in the corporation, which could be better utilized by the individual.
  • Although the key advantage of the corporation is to protect personal assets, most new corporations require the owners to personally guarantee any significant debt, which negates the limited liability advantage.

Overall, running a business through a corporation, whether it’s your music career or any other business, could provide significant advantages, but it only makes sense if the business is at a level that would benefit from tax deferral and/or is engaged in risky business contracts that could lead to potential defaults on debts or litigation.

If it’s a small business that generates small profits and has low risk activities, it’s probably better suited to be operated as a sole proprietorship.

As a warning, I’ve seen accountants who don’t truly understand the integration principle end up costing the owners of a corporation more tax than necessary, because they pay tax in the corporation and then turn around and pay salaries rather than dividends to the owners, which are not ideal in certain scenarios.

Please be advised that this is not meant to be tax advice. I highly recommend that you discuss this with your accountant. If you would like to discuss this matter with me, please call me at 416-313-2993.