There are both tax and non-tax reasons for considering the corporate form of business organization.
here are two potential significant tax benefits of incorporation for a small active Canadian business:
- A tax deferral is possible by retaining earnings in the corporation.
- The $500,000 capital gains exemption available for sale of a small business can only be claimed on the sale of shares of a qualifying corporation and not for the sale of a sole proprietorship or a partnership.
Net income of a sole proprietorship or a partnership is taxed directly in the hands of the owner. However, a corporation is a separate taxpayer with its own tax rates.
A corporation which is incorporated in Canada and is controlled by private corporations or individuals who are Canadian residents will normally qualify as a "Canadian-controlled private corporation". This status allows it to claim the small business deduction, a reduction of the normal corporate income tax rate on the first $200,000 of a corporation's annual taxable income earned from carrying on an active business in Canada.
The tax advantage which the shareholder of such a corporation with active business income will enjoy is the ability to defer the payment of some income tax. A corporation eligible for the small business deduction pays tax at about 25% on its first $200,000 of taxable income. The remaining tax, which is paid by the shareholders upon receipt of dividends from the corporation, is deferred until dividends are paid. When dividends are paid the balance of the tax is levied on the Shareholder.
The deferral is significant, especially for a taxpayer in the top marginal tax bracket, and means that approximately twice the funds are available for investment, since in effect tax money is being retained in the corporation and invested.
The Canadian tax system is designed, in certain instances, to be neutral between income earned personally or through a corporation. As a result, after the shareholder pays tax on his dividends, the total tax burden will be approximately the same amount he would have paid if the income was received directly.
This neutrality means that for non-active income of a corporation such as investment income or capital gains, the corporation effectively pays tax at the same rate as an individual. Accordingly there is no material tax deferral possible on passive income.
Capital Gains Exemption
The other main tax advantage to incorporation of a small business is the ability to claim the $500,000 capital gains exemption on a sale of the business. The complex rules provide, in effect, that to claim the exemption the shares must be of a Canadian-controlled private corporation, at least 90% of the assets of which are used in an active business carried on in Canada, or a holding company which owns such shares.
Where the shares qualify, the owner can sell them and the first $500,000 of capital gains are exempt from tax. Note that the exemption applies to the individual and not the corporation. Once an owner has claimed $500,000 of capital gains exemption, the exemption is no longer available on a sale of other qualifying shares.
Liability protection is generally the main non-tax reason to incorporate, and is the main motivation for most incorporations to take place. While a sole proprietor or partner in a general partnership has unlimited liability to creditors of the business, shareholders of a corporation have no such risk. Without the protection of limited liability most entrepreneurs would not take the risks of going into business.
While shareholders have limited liability, directors of a corporation are subject to various liabilities. These include liabilities for unremitted source deductions, unremitted P.S.T and G.S.T. and certain environmental liabilities.
Furthermore, passive directors who may not be involved in running the business may still be subject to certain of these liabilities. Passive directors should be aware of what the corporation is doing and should ensure that director's liability insurance is in place to protect them.
Disadvantages of Incorporation
Any business which is not operating at the break even point should not incorporate from a tax point of view, although it may be sensible to incorporate when considering limiting liability. A loss earned in a corporation cannot be transferred to its shareholders. Conversely, owners of an unincorporated business would be able to utilize losses which they incurred against other sources of income or against future earnings. Losses which arise in a corporation can only be offset against earnings in that corporation.
A potential double taxation trap exists if an active business earns too much profit.
Corporate profits from active business income in excess of $200,000 per year are taxed at full corporate rates. Integration of the personal and corporate tax systems does not work at that rate, resulting in an element of double taxation. Therefore all income in excess of $200,000 should usually be paid out of the corporation by way of salary or bonus to avoid this double taxation trap. If the corporation requires the funds for operations, the income can be paid to the shareholder and then loaned back to the corporation. The salary receipt is, however, taxable to the shareholder.
A corporation is also subject to strict rules governing the taxation of shareholder benefits, such as shareholder loans or the use of a company car.
Finally, the transfer of the unincorporated business or partnership to a corporation will be a taxable transaction unless a rollover agreement is made and the appropriate election is filed with Revenue Canada. Provided such an election is made, however, the transaction can be free of any immediate adverse tax implications.
When a proprietorship or a partnership incorporates, it is generally a good idea to consider any life insurance needs. Upon the incorporation of a partnership, a shareholders agreement will normally be entered into, often requiring funding through life insurance. An incorporated sole proprietorship may not have any additional life insurance requirements, but in certain circumstances, such as the entrepreneur being a single parent, additional life insurance to pay for any deemed capital gains incurred on the death of the shareholder might be appropriate.
"This article provides information of a general nature only. It may no longer be current. It does not provide legal advice nor should it be relied upon. If you have specific legal questions you should consult a lawyer."