Incorporation is the creation of a corporation which is a separate legal entity. This entity can have its own assets, debt, revenues, and expenses. A corporation may limit the legal liability of the corporation’s assets. In contrast, an individual who is not incorporated would run their business as an individual, with all net income on their personal tax return. An unincorporated individual would hold assets and liabilities personally.
What are some Benefits of Incorporating?
Tax Deferral – Low Corporation Tax Rate
The combined corporate tax rate of Canadian resident corporations in BC with net income of $500,000 or less, has been lower than 12 percent for years, at the time of writing. In contrast, an unincorporated individual would be taxed at graduated rates closing in on 50 percent for income in excess of $200,000. There is a significant difference in income tax rates at the corporate level versus the personal level.
Hence, for the individual whose earnings exceed individual expenditures, a tax deferral strategy via a corporation is ideal. The low corporate tax rate leaves more funds for the corporation to invest.
There is one caveat. A corporation can earn up to $50,000 of investment income in the prior year with no impact on the small business deduction. But, for every dollar of passive income over that amount, $5 of the deduction is lost. That means once passive income exceeds $150,000, the corporation loses the small business deduction entirely. However, investment income could be reduced at a corporate level through additional tax sheltering strategies.
Incorporating may allow you to take advantage of income splitting opportunities. There are two main approaches to income splitting:
- Dividends: By having lower income adult family members as shareholders, the incorporated business can pay them dividends to take advantage of their lower marginal tax rates (sometimes referred to as “dividend sprinkling”). Starting in 2018, dividends paid to related shareholders were subjected to a reasonability test although there are certain exemptions (e.g. paid to the spouse of a shareholder that is aged 65 or over, and family members aged 18 or over who work at least 20 hours a week in the year or any past five years ). Dividends should not be paid to children under 18. The dividend would be taxed at the highest personal tax rate regardless of the child’s marginal tax rate.
- Salaries: An individual can pay a family member to perform work for the corporation. However, the Canada Revenue Agency (CRA) requires that the amount paid be reasonable for the work performed; this is defined to be the amount that would be paid to an unrelated person for the same work.
What are the Disadvantages of Incorporating?
Since a corporation is a separate legal entity, the complexity of tax compliance increases. As a result, there will be additional legal, accounting, and tax filing fees. An individual who is using all of his or her earnings – to pay debts, for example – would see little to no tax benefit from incorporation; in this case incorporation is an unnecessary expense. For many others however, the benefits of incorporation can considerably outweigh the costs.
Consider incorporating in order to take advantage of low corporate tax rates, thereby leaving you with more cash to invest through the corporation. Further, when you own a business, consider employing family members. Lastly, ask your tax and legal advisors about adding family members as shareholders of your corporation.