What does incorporation mean?
When a business is incorporated, a new entity (company) is created which is legally distinct and separate from the individual shareholder. The individual typically becomes an employee of the company and is engaged to provide services to the business. The company operates the business, sells the inventory, acquires assets, and pays expenses associated with the corporation (rent, supplies, wages, etc.).
The individual will receive shares in the company. These shares will allow him or her to own and control the company. The shareholder will usually receive income from the company in a combination of:
(i) salary for services rendered as an employee and
(ii) dividends on the shares owned.
As a distinct legal entity, the company will be required to file its own income tax returns and pay its own income taxes. The amount of corporate earnings subject to income tax will be net of all deductible expenses including any salary paid to the individual shareholder. This corporate tax return is in addition to the personal income tax return that each individual will continue to file.
One of the primary reasons to consider incorporating is that corporations generally pay income tax at lower rates than individuals. The general Saskatchewan corporate tax rate is 27%. However, since most incorporated businesses will be considered Canadian controlled private corporations earning active business income, the combined federal and Saskatchewan small business deduction (SBD) reduces the income tax rate on the first $500,000 of taxable income to 12.5%.
The SBD rate applies to taxable income earned and retained in the company. Since individuals may require a salary to fund personal cash needs (basic living expenses, mortgage, personal debt, etc.), the lower corporate rate will only apply to corporate income after deducting salaries paid to the individuals.
In Saskatchewan, varying rates of tax apply to taxable income; however, taxable income above $200,000 is taxed at the top personal rate of 48%. Assuming net business income of $150,000 and a reasonable salary to the individual of $60,000, Appendix A attached outlines the total taxes that would be payable if the income was earned by the individual and, alternatively, if the income was earned by a company with $60,000 paid as a wage to the individual shareholder and $90,000 retained by the company.
As illustrated, total taxes are reduced by almost $22,000 under the corporate alternative; however, this reduction is only a deferral in that the after tax corporate income cannot be paid out to the shareholder unless additional personal income tax is paid. In the simple scenario of an individual withdrawing all corporate income in the same year as it is earned, the shareholder would pay almost the same amount of tax as if he or she had earned the income directly. Note there would be a 0.45% income tax savings on earnings subject to the SBD. The Canadian income tax system is designed such that income distributed to a corporation’s shareholders (either as a dividend or salary), results in the shareholders paying essentially the same amount of tax as they would if the income was earned directly by the individual.
As illustrated in Appendix A, active business income retained and taxed in a company is subject to a 12.5% rate of tax. Consequently, the company has available to invest $0.875 of every dollar earned. If the individual earned the income personally and was taxed at the top marginal rate of 48%, he or she would only be able to retain $0.52 of each dollar earned. This additional cash retention by the company becomes extremely important for those businesses that are expanding an existing operation or have a significant amount of debt to retire. By incorporating, the business can repay debt sooner by retaining significantly more after tax income in the company.
By reducing the time required to repay business related debt, incorporation will allow the business to begin to invest in other opportunities.
Corporations normally provide limited liability, i.e.., their shareholders cannot normally be sued beyond their invested capital for the actions or debts of the corporation. The shareholder’s liability would normally be limited to activities undertaken by the corporation (unless personal guarantees have been provided).
Repayment of Existing Capital
Where an individual transfers business assets to a corporation, he or she is entitled to extract the tax value of the assets on a tax-free basis because the funds to purchase these assets have already been taxed. Consequently, an individual may have access to a significant pool of capital to invest at a personal level.
Capital Gains Deduction
A sale of an incorporated business may be structured as a sale of the shares. Only 50% of any capital gain that results is taxable. If all of the criteria are met, the capital gains on qualifying small businesses and farm corporations can be sheltered from income tax with the use of the capital gains deduction (CGD). The CGD reduces or eliminates the income taxes on qualifying capital gains. All individuals resident in Canada have a lifetime CGD limit of $824,176 (indexed annually for inflation).
Fiscal Year Flexibility
An unincorporated business must use the calendar year for income tax purposes. An incorporated operation can choose a non-calendar year, which may be more appropriate to the business cycle.
Spouses and children may become shareholders of the company. As such, any dividends they receive will be taxed in their hands, thereby reducing the overall incidence of tax borne by the family unit. Dividends to children that are under 18 years of age however, will be subject to additional taxes in some circumstances. A family trust can be used to own the shares of the corporation which allows family members to participate in the benefits of share ownership while the parents maintain control of the corporation. The family trust can also be used to multiply access to the CGD.
Individual Pension Plan
The corporate structure allows for participation of the business owner in an Individual Pension Plan (IPP). An IPP is not available for proprietors or individual partners. An IPP can result in additional income tax deferral amounts.
Incorporating a business may have certain disadvantages and additional costs to consider.
Set-up Costs and Maintenance Fees
A business that is incorporating will have to pay for tax planning advice; legal services to set up the corporation and accounting and legal services to transfer the business assets to the corporation. He or she may also need to obtain a valuation or an appraisal of the various business assets in order to substantiate the transfer price.
On an annual basis, legal fees will be incurred to maintain the corporate registration. As well, accounting fees will be incurred to prepare annual financial statements and income tax returns.
Income Tax on Investment Income
Investment income (interest, dividends, rents, etc.) is generally not eligible for the low rate of tax on active business income. If investment income is earned in a corporation, the combined corporate rate of 50.7% is higher than the top marginal personal tax rate of 48%. That corporate rate; however, includes a refundable portion of 30.7% which is refunded when the corporation pays an appropriate amount of taxable dividends.
There is; therefore, a slight disadvantage in having a corporation earn investment income.
Complexity and Restriction on Withdrawal of Funds
As the corporation is a separate legal entity from the individual shareholder, the parties must interact accordingly. All earnings of the business belong to the corporation. They can only be passed on to the individual with the appropriate income tax treatment and documentation. This restricts the individual from freely withdrawing funds from the corporation, unlike a business operated as an unincorporated entity.
INCOME TAX CONSEQUENCES OF INCORPORATING A BUSINESS
Analysis of Tax Returns
Alternative 1: Business operates as an individual and has net income of $150,000.
Alternative 2: The business operates as a corporation, has net income of $150,000 before a salary to the operator of $60,000.
|Taxable income reported on personal tax return
|Total federal and provincial income taxes
|Net after tax funds available
Taxable income in corporation ($150,000-$60,000)
Corporate income tax (federal and provincial)
|Net after tax funds available
|Taxable salary to operator
|Personal income tax (federal and provincial)
|Net after tax funds available
|Total income tax under Alternative 1
|Total income tax under Alternative 2
|Total income tax deferred under incorporation
Should I Incorporate My Business Operation?
Several items must be considered in the decision to incorporate.
- Goals of the operator.
- Intention of children to be active or non-active in the business.
- Estate planning matters.
- Levels of current debt.
- Income tax brackets.
What are the Advantages of Incorporation?
- Small Business Income Tax Rate in Saskatchewan is 12.5% on the first $500,000 of taxable income. The income tax rates at the personal level range from 26% to 48%. The lower corporate income tax rates result in greater after-tax cash retention in the company.
- After-tax retention in the corporate structure, 87.5 cents of each $1 will be available to:
- Flexibility in Income Tax Planning exists with a corporate structure. The individual, depending on cash needs, may be remunerated through salary, dividends or no remuneration at all if income tax planning suggests that is the best approach. The corporate structure adds tax planning possibilities such as Individual Pension Plans which can defer income. In some cases, the capital gains deduction can be utilized to reduce income taxes on the sale of the business.
- Income Splitting opportunities exist through a corporation that are not available at the unincorporated- level. The ability to pay dividends to shareholders can be a major advantage in some circumstances.
- Flexibility in Estate Planning - Under the Income Tax Act, the shares of a qualifying small business corporation are given the same preferential treatment as the qualifying assets outside the corporation. Shares can be transferred to the next generation on a tax deferred basis, through use of the capital gains deduction or, in some cases, a rollover.
- Tax Installments may be deferred in the first year.
- Limited Liability will afford additional protection to the business owner.
What are the Disadvantages of Incorporating?
- Investment Income - An income tax disadvantage can arise when investment income is earned in a corporation, as the combined corporate rate on investment income is higher than the top marginal personal tax rate.
- Costs of incorporating a company include accounting, legal, and corporation branch fees estimated to be a minimum of $2,000 to $2,500. Where existing assets are to be transferred into a corporation, the legal and accounting costs would be in addition to the costs of incorporation and would likely be a minimum of $2,500. These fees could be significantly more depending on the complexity of the existing business structure.
- Administration - The corporation is required to file annual returns with the Corporations Branch and annual T2 income tax returns with the Canada Revenue Agency. Costs of filing the required financial statements and T2 income tax return would be approximately $2,000 to $3,000 per year for a compilation engagement and could be higher depending on the quality of the accounting records.
- Complexity and Restrictions on the withdrawal of corporate funds for personal use and possible- tax consequences associated with the personal use of corporate assets.
- Credit ratings may have to be re-established as the corporation is a new entity with no history of borrowing.
Are There Any Other Matters to Consider?
Yes, many. Some of these are:
- What assets to include in the corporate structure.
- Is the question of incorporation considered due to a short-term problem or will the problem persist over a longer period.
- Where an individual has significant deferrals of income or potential income tax liabilities on disposition or deemed disposition of inventories, the corporation may be a method of minimizing the tax consequences.
- New entity - bank, advising suppliers.
- Share structure, e.g.. who will be included as shareholders, will they have voting shares, etc.
If you are considering incorporation, you should meet with your Chartered Professional Accountant to discuss the incorporation process. These discussions are meant to examine your goals, identify issues and possible solutions and to determine if a preliminary engagement should be undertaken.