AUTHOR: April Wheeler, CPA, CGA, B.COMM
This is a question accountants and lawyers are asked often and the answer - is almost always - “it depends”.
A corporation is a separate legal entity which means the corporation pays corporate income tax which is calculated completely separate from the owner’s personal income tax. In addition, if the corporation pays wages to the shareholders, income tax, CPP premiums and possibly EI premiums, must be deducted and remitted to the Canada Revenue Agency.
No matter whether or not your business is incorporated, spouses and children can be employed by the business, which effectively is income splitting. However, amounts must be reasonable based on the services provided and must actually be paid to the spouse and/or children.
To determine whether incorporation makes sense for your business you need to look at the advantages and disadvantages of incorporation and determine whether or not the advantages outweigh the disadvantages.
Advantages of incorporation:
Unlike a sole proprietorship, where the business owner assumes all the liability of the company, when a business is incorporated the liability of the shareholders of the business is usually limited to the amount they invested in the corporation. If you are a sole proprietor, your personal assets, such as your house and car can be seized to pay the debts of your business; as a shareholder in a corporation, you can’t be held responsible for the debts of the corporation. There are a couple of exceptions. The first being often small corporations are not able to get bank loans without a personal guarantee of the shareholders, which means the advantage of limited liability is eliminated. Second shareholders who are directors of the corporation can be held legally liable for payroll taxes and HST in certain circumstances.
A Canadian controlled private corporation pays a much lower rate of tax on its first $500,000 of taxable income relative to what would be paid by an unincorporated business owner. In 2016, the current combined federal and Ontario tax rate on the first $500,000 of active business income in a corporation is 15.5%. By contrast, a sole proprietor in Ontario with business profits pays tax on the first $220,000 of profits at rates between 20% and 50%. While business profits in excess of $220,000 attract a personal tax of 53.53%.
If you do not need all your business’ earnings to pay for personal living expenses, you can leave the earnings in the corporation and defer personal taxes until the earnings are withdrawn from the corporation. For an Ontario business owner paying personal tax at the top marginal rate – this tax deferral is approximately 38%.
As a shareholder of the corporation, you are entitled to a capital gains exemption of $813,600 upon the sale of your shares – provided your business meets the definition of a qualified small business corporation and certain other requirements are met prior to sale.
A corporation allows the shareholder flexibility and the ability to choose the most tax-efficient way to pay yourself, including dividends, salary, bonus or a combination. Dividends can be used to as a way to split income with your spouse if he/she is a shareholder of your corporation.
Corporations Carry On
Unlike a sole proprietorship, a corporation has an unlimited life; the corporation will continue to exist even if the shareholders die, leave the business or the ownership changes. Selling a corporation is more straightforward than attempting to sell a sole proprietorship.
Disadvantages of incorporation:
Set up costs
Incorporation can be a complicated structure and it is important to seek professional advice on the proper classes of shares, who the shareholders will be (spouses, children) and which shareholders will have voting control.
Business losses cannot be written off against other income of the shareholders.
More administrative costs are incurred due to annual financial statement and corporate tax return fillings required in addition to the shareholder’s personal tax returns.
In very general terms, if you need all the profits of your business to live on, then you don’t need to incorporate because you have no income to shelter.