One of the most common questions we get from small business owners is whether or not they should be incorporating their small business. They could be an established business currently operating as a sole proprietorship, or often they are just starting their business and want to decide on a structure from the get-go.
The answer is that there is no one-size-fits all solution to this question, but lets look at some of the basic criteria that we use to determine if incorporation makes sense for a small business.
Creditor proofing and limited liability
This is the number one non-tax reason for incorporating. Shareholders can protect themselves from most liability through the corporation’s limited liability status (there are some exceptions for professionals), meaning that an individual can protect themselves and their personal assets from claims against the company. If an incorporated business is sued, the only assets the creditor can come after are the corporate assets, not the personal assets.
You might be asking yourself, “Okay, but what about my corporate assets? Don’t I want to protect those too?” Taking the limited liability a step further, you can reduce your corporate exposure by creating a holding company in between you and your operating company. Taking advantage of inter-corporate dividend rules, the active business can transfer its excess cash and other assets to the holding company on a tax-free basis. Since the holding company is not susceptible to claims from creditors of the operating company, you have now protected these excess assets.
There are three significant tax benefits to incorporating that many business owners may be able to take advantage of; income splitting, income tax deferral, and the lifetime capital gains exemption. Lets take a look at each.
i) Income splitting
A properly structured corporation can allow for more flexible income splitting opportunities than a sole proprietorship. Corporations allow the splitting of income with a spouse and children over 18 years old through the use of discretionary or “dividend sprinkling” of shares. Dividends allow more flexibility than paying a salary to family members, as salaries are subject to a reasonability test whereas dividends are not.
For example, if you have a spouse that stays home with the kids while you are the primary income earner for the family, it would be difficult to pay the stay-at-home spouse a salary of any significance if she does not do any work for the business. The CRA could disallow the corporate deduction for what they deem is the excess salary. Having the spouse as a shareholder allows you to dividend approximately $40,000 per year without generating any additional tax (assuming no other sources of income), and without the worry of it having to be reasonable.
If we took a very high level example based on the 2016 income tax rates, a sole proprietor that earned a net income of $150,000 personally would have paid approximately $47,000 in tax, leaving them with net income of $103,000. Now, take that same shareholder, and give him $150,000 of income before tax in his corporation. He would pay $22,500 in corporate tax, and could dividend out $40,000 each to himself, his spouse, and adult child without paying any further tax, and still have $7,500 leftover in the company. That is a $24,500 tax savings.
This is meant as a very simplified example of what is possible through income splitting. There are other considerations that this blog post doesn’t cover, but we’ll dig into that in a blog on shareholder remuneration in the near future.
ii) Tax rate deferral
A company earning active business income (i.e. not investment/passive income such as real estate rental or portfolio investments) is only subject to a 15% small business tax rate on up to $500,000 of taxable income in Ontario. The personal tax rate can be as high as 53.53% in the highest tax bracket (over $220,000). This is where the tax rate differential and the tax deferral concept comes into play.
Lets take another simple example of a couple that owns a business and has a great year where they generate $500,000 in pre-tax income. The couple desires a lifestyle that requires $120,000 per year to cover expenses and personal savings. In the company, they would pay $75,000 of tax leaving net income of $425,000. They pay themselves dividends of $5,000 each per month, or a total of $120,000 for the year on which they pay $8,000 in tax. Therefore, the total tax paid using this strategy is only $83,000 and the company is left with $305,000 on which tax has been paid, and can be drawn in the form of dividends in later years. Had that $500,000 been earned personally, or had it been fully paid as employment income to the spouses, they would have paid nearly $200,000 in tax. This is where the tax deferral becomes apparent. The couple could either keep that $305,000 in the company to reinvest and grow, or they may park it in a holding company as discussed earlier and draw dividends during leaner years, or save it as part of an overall retirement strategy.
iii) Lifetime Capital Gains Exemption
You may be building a business that you know will be saleable in the future at a substantial value. The capital gains exemption is a significant benefit to holders of qualifying small business corporation shares as each shareholder can be entitled to use their exemption of $824,177 each (indexed annually for inflation). What this means is that if you and your spouse are the shareholders, you can sell your business for over $1,600,000 on a tax-free basis.
There are also methods to multiply the capital gains exemption to include adult children, which are beyond the scope of this post, but should be considered with your accountant.
There are also some factors requiring advance planning that can affect the access to the capital gains exemption. Proper planning should be considered with your accountant well in advance of a sale (more than 2 years), to ensure that when its time to sell you will qualify.
When is the right time to incorporate?
While the benefits outlined may seem quite clear, incorporating is still not for everyone. If you don’t feel that you will be able to benefit from some of these strategies, you may want to continue with a sole proprietorship for the time being. Keep in mind that incorporating does cost more than a proprietorship both for initial set up and for ongoing legal and tax compliance, so there has to be a real benefit that outweighs this cost.
If you are in an industry that is subject to lawsuits, maybe the limited liability aspect of the corporation is the one factor that will drive you to incorporate. If you are generating into the six figures of net income, generally that is a good threshold to consider it as you may have some immediate tax deferral or splitting opportunities to take advantage of.
Every situation will have a different answer and we hope that we can help lead you in the right direction with the guidance provided. Please contact us for more information or a personal consultation on this topic.