What Every Canadian Small Business Owner Needs to Know
Here is what we will cover in this post:
Are you thinking about incorporating your small business? You probably know a fellow entrepreneur that has. When it comes to incorporating your business there is a lot of misinformation floating around out there. Yes, corporate tax rates are lower than personal tax rates (for the most part) but it’s not a black and white situation. Saving on tax can be one of the main reasons business owners decide to incorporate. There are also other factors that might motivate this decision. Factors such as the ability to sell shares of your business to raise capital. Whatever your situation may be, getting educated on incorporation is your best approach. There may be legal reasons you may wish to incorporate a business and we suggest talking to a lawyer about that. In this blog we will stick to the tax implications of incorporating your business. Read on.
A corporation is a separate legal entity. It can enter into contracts and own property in it’s own name, separate and distinct from its owners. In this way a corporation is also a taxpayer. On the other hand, as a sole proprietor, you and your business are one and the same. There is no separate legal entity. All income generated by the business is taxed personally to the proprietor - that's you!
Because a corporation is a separate legal entity it pays corporate tax on taxable business income. Shareholders own shares in the corporation and can be compensated through either salary or dividends. Both have an impact on the personal tax of the shareholder. Salary requires registration for a payroll number with the CRA as well as annual T4’s and source remittance contributions. Dividends do not require a payroll number but do require an RZ information account, which allows T5’s to be issued to the individual shareholder receiving the dividend.
Money left in the corporation (profit from active business that is not paid out as salary) is taxed at a lower tax rate than most personal income. So this means that by leaving money in the corporation and not paying it out to yourself personally you can defer those higher rate personal income taxes.
Yes, corporate tax rates are lower than personal tax rates (for the most part) but it’s not a black and white situation.
There are a lot of benefits that come from incorporating. The main one, which we mentioned above is lower tax rates. If you are able to leave money in the corporation after paying yourself and that money is taxed at a lower rate. This enables you and your tax advisor to do some tax planning. Tax planning can be particularly useful for businesses that have income that can often be volatile (feast or famine). Incorporating can allow you as a shareholder to smooth your compensation to make the income peaks and valleys less noticeable and also make your personal taxes more favourable.
Succession planning is another reason small businesses incorporate. If you are planning on passing your business to your children. Incorporating allows you to freeze the value of your shares. This allows your children to take over and continue building without sacrificing the nest egg you have worked hard for.
Funds held in a corporation can also be used as part of retirement planning. You can save excess income in the corporation at a lower tax bracket. When it comes time to retire you can pay yourself out of the corporation. Just be aware of higher corporate tax rates on investment income and the passive income grind. If you are planning to use a corporation to assist in retirement planning it is best to seek personalized advice.
If you are planning on raising capital to fund business growth, incorporating makes this possible. You are able to sell equity (ownership) in your business only if your business is incorporated. A related benefit is the lifetime capital gains exemption on qualifying shares. In short- if you choose to sell shares you could be exempt from paying capital gains tax on that sale up to a threshold if the business qualifies.
Incorporating your business is not a decision to be taken lightly and certainly not a decision you want to make without the guidance of an accountant and a lawyer, which is where we come in...
This brings us to the main reason people incorporate their businesses. Incorporated businesses are eligible to take advantage of the Small Business Deduction on active business income for Canadian Controlled Private Corporations. This means that particular income up to $500,000 is taxed at a significantly lower rate than most personal tax rates. The caveat here is that to pay lower taxes as a whole you have to leave money in the corporation. If you are taking all the profits out of the corporation in order to pay yourself and fund your personal expenses, there really is no tax saving benefit to incorporating. You will still be taxed at the personal tax brackets in your respective province.
Which brings us to…
Incorporation adds a new layer of complexity to your business. Once you incorporate you have added compliance requirements such as the T2 corporate tax return, T4 and T5 and possibly period payroll cycles to administer. Filing corporate tax returns properly is quite complicated. We never recommend people DIY their corporate tax returns - this is something you definitely need a professional to help with. This means added costs such as legal, accounting and bookkeeping. Your tax advisor will be able to run a cost-benefit analysis to determine whether the ongoing cost of incorporation is worth the potential tax savings inside the corp.
Incorporating can actually leave you on the hook for higher tax rates on some types of income. As an example, investment income is taxed higher. So not all income inside of a corporation benefits from that lower tax rate mentioned above. As we said earlier - it’s not black and white.
Incorporating your business is not a decision to be taken lightly and certainly not a decision you want to make without the guidance of an accountant and a lawyer. It is important to run the numbers and determine whether it makes sense to take this big step in your business.
The benefits can be substantial, especially over the long term. That being said, too many people incorporate prematurely and are left with higher bills and increased compliance requirements without the benefits they were expecting. Worse, they might actually be hurting themselves financially if the business suffers losses after incorporating as those losses will be trapped in the corporation.
So how do you know when you should be thinking about it for tax purposes? As a rule of thumb, once you are generating more profit than you need to live on, you should have a discussion with your tax advisor (if they haven’t tapped your shoulder already). Additionally, if you plan to raise funds for your business, a corporation will be the vehicle through which you do that. Proceed with caution and make sure you weigh all the pros and cons before jumping in.
Wishing you success in your business,
- Martina + Ashli
p.s. found this helpful? Get the answer about incorporating tailored to your specific business using our Should I Incorporate tool.
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Date published: March 1, 2022
Disclaimer - The information provided in this blog is general in nature and solely for educational purposes. Readers use and implementation of the information comes at their own risk and is their own responsibility.