An Overview of Corporations
When clients ask me to explain how corporations work, I often draw the comparison between incorporating a corporation and having a child; when you incorporate a new corporation, you are bringing into the world a new entity that will go on to be separate and distinct from the incorporators who created the corporation. The new corporation will have its own ability to own assets, enter into contracts, sue and be sued, and conduct business operations in its own name. It is important to understand that while a person can be the sole shareholder (effectively the owner of the corporation) and director (the controlling body of the corporation), the corporation is still its own separate and distinct entity from that shareholder or director.
Some benefits of Incorporating include:
Limited Liability: Incorporating your business limits your personal liability for the business's debts and legal obligations. This means that if the business is sued or goes bankrupt, your personal assets are protected, subject to some exceptions which we will discuss in a separate article in the future.
Perpetual Existence: A corporation can exist indefinitely, (provided that annual reports are filed), regardless of changes in ownership or management.
Marketing Credibility: In some industries, such as for real estate agents, having a professional corporation, such as a Personal Real Estate Corporation (PREC) is often seen as a sign of prestige and success.
Tax Advantages: Corporations can take advantage of certain tax benefits that are not available to sole proprietors or partnerships. (This will be the main point of discussion for the purpose of this article.)
However, there are some disadvantages to incorporating as well:
Additional Maintenance Costs: There are maintenance costs associated with filing annual reports and annual taxes for the corporation. It is normal for accounting costs to be higher for corporations than sole proprietor businesses. For some specialized industries, such as for real estate agents, operating through a corporation may require additional licensing fees to be paid to operate through a professional corporation.
Lack of Tax Loss Flow-Through: Expenses and capital losses are used as tax deductibles used to offset an entity's income. Since a corporation is its own entity, the shareholder would not be able to enjoy the benefit of using the corporation's expenses and tax losses to offset against the shareholder's own income; and such deductibles are "trapped" within the corporation, only to be used to offset against the corporation's own income. If the corporation does not become profitable, such tax-deductible may never be used.
Overview of Tax Advantages of Incorporating (Tax Deferral and Income Splitting)
Before we dive into the tax strategies involved in dealing with corporations, it is important to understand the policy of tax integration, which is a guiding principle in Canadian taxation:
Tax integration is a tax policy that aims to eliminate double taxation of corporate earnings by integrating the tax treatment of corporate profits and dividends received by shareholders. In other words, it seeks to ensure that corporate earnings are taxed only once, either at the corporate level or at the shareholder level, but not both.
Under a tax-integrated system, corporate profits are subject to corporate income tax, and dividends paid to shareholders are taxed at the personal income tax rate. The tax system is designed in such a way that the combined tax paid by the corporation and the shareholders is roughly equivalent to the tax that would be paid if the profits were earned by an individual. This is done in relation to dividends paid to shareholders through a "gross-up" and tax credit mechanism. We will not go in-depth into how this mechanism works in this article, but the key point to understand is that in principle, under the tax integration policy, there should be little to no difference between an individual who operates through a corporation, and one that conducts business directly (sole proprietorship).
You may ask at this point: if we have a tax-integrated system in Canada, how can we derive any tax benefit at all through a corporation?
The answer is that tax integration works if every dollar earned through the corporation is also withdrawn in a given taxation year, but it is still possible to enjoy tax benefits through some planning. To understand how this works, we need to understand a few other tax concepts:
The small business deduction (SBD) allows Canadian-controlled private corporations (CCPCs) to enjoy a reduced rate of tax on active business income up to $500,000 (do note that this number may change and is subject to adjustment based on how much passive income is made by the Corporation or related entities). The tax rate for corporations that can enjoy SBD is often around 11%-13%, which is much lower than if the same income is made by an individual.
The marginal tax rate goes up as an individual's annual earning goes up, for example, the combined tax rate for active income in 2023 for an individual earning $46,654 is 20.06%; but once that individual makes over $46,654, the next dollar, up to a new limit is at a different tax rate. For the amount between $45,654 and up to $53,359 the tax rate becomes 22.70%. The more you make in a given year, the higher your effective tax rate will be, as a result of how the how tax brackets are progressive in nature in Canada.
With a corporation, it is possible to "defer" taxes. For dividends issued to a shareholder, such income will be taxed once on the corporation side, and again when it is issued to the shareholder; the aggregate result would be not much different than if you were to just earn the income directly rather than through a corporation. However, if do not need to use the earned income immediately, you can choose to leave the income earned by the corporation in the corporation itself, in which case, it would only be subject to the one level of corporate taxation (which you will note is much lower than your individual tax rate if the corporation is earning less than $500,000 of active income). You can then plan and choose to withdraw the saved amount at a later date and "defer" the need to pay taxes. This can also create a lower "effective" tax rate over a period of time by evening out your income.
Let me illustrate how the above tax deferral mechanism works through this example:
Let's say you are a real estate agent, but the market is very unstable. In years 2021, you made $220,000 through your Personal Real Estate Corporation (PREC). However, in 2022, you found that the real estate market is weakening, and because of a leg injury, you did not work nearly as much as the previous year, resulting in an income of $20,000 made through your PREC in 2022. Under normal circumstances, if you are not incorporated in this example, you would have an effective tax rate of approximately 35% in 2021 and 20% for 2022; resulting in an effective tax rate of approximately 33% across two years if we combine the tax paid on total income and average it over the span of two years, Imagine now, that you can "even out" your income, by effectively allocating the aggregate income of $240,000 evenly across two years for an average of $120,000. In this case, the average tax rate across both years is roughly 28.7%, which is evidently lower than 33%. Through a corporation, and by using tax deferral, if choose to "defer" excess income to be taken out in the future when you are earning less, (in a similar but not exactly the same fashion as the hypothetical I presented above), you can also create a lower effective tax rate for your self over the span of multiple years. As a disclaimer, the above example has been greatly simplified for your understanding. The actual calculations are more complicated and involve calculating the company's tax rate and adjusting for both a "gross up" of the dividend and receiving a tax credit. The important point to understand here is that through tax deferral and "evening out" your income, you will pay less tax over the years, provided that you plan your taxes strategically. Make sure you obtain tailored tax advice from a certified professional accountant to work out a tax plan that can make use of the tax deferral benefit we discussed here. You can also use the same strategy to defer taxes for retirement planning. This strategy is especially useful for any businesses which have erratic changes in earnings from year to year.
Aside from tax deferral, through a corporation, you can pay also allocate salaries or dividends to different shareholders, potentially allowing you to split income among family members who may be in a lower tax bracket. The tax saving concept is similar to the tax deferral method above. Do note, however, there are restrictions to when income-splitting strategies should be used. Salaries paid are required to be "reasonable", so you may not allot salaries that would be a marked departure from what is reasonable in the open market. Dividends on the other hand are also subject to Tax On Split Income (TOSI) rules which will penalize dividends paid to family members who have not contributed significantly to the corporation's business. The rules surrounding TOSI are relatively new and have many fine points, so again, make sure you seek tailored tax advice from a certified professional accountant before conducting any income-splitting strategies. Where it is appropriate and given the correct circumstances, income splitting will also allow for significant tax savings over the long term when considering net tax payable for your family as a whole.
In the next article, we will discuss other tax benefits to incorporation, including the lifetime capital gain exemption, and succession planning through the use of rollovers. Lastly, please be advised that these articles provide a very simplified version of tax strategies businesses may implement to their benefit, but are neither legal nor tax advice. They are provided to illustrate that there are certain tax advantages to incorporating, but they are not replacements for tax advice from a certified professional accountant. Each person's individual circumstances may significantly alter what type of tax strategies would be suitable.
If you are interested in incorporating, feel free to contact us at info@triviumlaw.com, or by calling us at 604-242-1578.