Time to Incorporate?

 

Article by Jonathan Wright

Most businesses reach a point where this becomes an important question: whether or not it’s time to incorporate. There are costs involved but the tax and legal benefits can be significant. The purpose of this note is to tease out some of the benefits of incorporation to see whether the time is right for you to incorporate.

Defer tax

At the time of writing, the small business rate for corporations is 12%. Compare that to the top tax rate for individuals of 49.8% and you can see why incorporating might make sense.

To be clear, the government eventually makes up the difference. When a shareholder takes her dividend from the corporation, she pays tax on the dividend essentially equal to her individual marginal rate minus the tax already paid by the company. As a result, if a person is taking out of her business all the income it makes in the year (say, to pay down her mortgage), tax deferral won’t provide much benefit. However, if the shareholder is able to hold off on receiving the cash, perhaps reinvesting profits back into the business, this tax can be deferred.

The small business rate isn’t available for all corporations. However, carry on an active business (providing services say, or selling products) or have sufficient employees in your passive business and this rate should be available to you.

Limited liability

A corporation is a separate entity—another “person” in legal speak.

This means that if the corporation is carrying on a business and runs into a problem (your widget injures a customer or a bank calls in a loan) the liability stops at the corporate level. The creditor might sue for the company’s assets but it won’t have access to that of the shareholder, like a home or cottage. There are exceptions to this (fraud being a glaring example or when a shareholder guarantees company debt), but the general rule is that liability doesn’t pass through the corporation.

Income splitting

Despite the recent tax changes in Canada, income splitting is still available for many types of businesses. This note will not address the new rules in detail. However, in paraphrase, income splitting will still be available where the shareholder meets share ownership requirements and the business is not a professional corporation, or where the shareholder provides sufficient contribution to the business.

Where available, income splitting might be the most significant benefit of incorporation currently available. Income splitting with a spouse as an employee is available before incorporation, but pay must be reasonable. If a business-owner pays her spouse $200,000 to do bookkeeping for five hours a month, this may be flagged by the CRA and the deduction disallowed.

On the other hand, permitted income splitting through a company isn’t subject to reasonability requirements. If the company is set up properly the company can issue dividends to whomever the director chooses, and in whatever amounts. Assuming business and shareholder requirements are met, taxes can be reduced via a careful distribution of income.

Lifetime capital gains exemption

I’ve covered this area in more detail in an article I wrote some time ago. In brief, every Canadian has a lifetime capital gains exemption which is indexed to inflation ($848,252 at the time of writing) on the sale of shares of a corporation. There are requirements that need to be met (some of them recently introduced by the federal government) but, if satisfied, the result is that on the sale of shares of your company, $848,252 in gains is exempt for each shareholder.

Time to incorporate?

If you are considering whether incorporation makes sense for you or are looking for tax advice on whether setting up a trust or holding company will be beneficial for your business, please do not hesitate to contact the author at jwright@wrightlegal.ca or 604.678.4459, or visit our main page at wrightlegal.ca.