Here is another entry from Ed Rempel regarding if you should incorporate your small business. I was asked this question from Qubikal, but I asked Ed to answer as he has experience in this field.
This topic was requested by a reader and is a question I am often asked. The issues are all tax and legal, and can be intimidating. However, they can be summed up with a few questions.
- Is there a reasonable risk my business might be sued some day?
- Does my business make a good income that I don’t need to spend or reinvest now?
- Can my business be sold for a significant amount of money?
Your business can be either a corporation or a sole proprietorship, which means your business is you and taxed on your personal return.
1. Risk of being sued:
One major advantage of having your business as a corporation is that if you are sued, you can usually avoid being liable personally. At worst, usually only the assets in your corporation can be lost if you lose a law suit. Law can be somewhat arbitrary, so you might well lose even if you didn’t really do anything wrong. However, some businesses are much more likely to be sued than others.
2. Tax deferral:
Corporation tax and how it fits with your personal tax can be complicated, but can also be summed up into one major concept. If your business makes $100,000 and you spend the money, all the tax rules are designed so that you pay about the same total tax whether you business is a sole proprietorship or a corporation.
The advantage of a corporation is a tax deferral. The income is initially taxed in your corporation at a lower rate, and then you pay the extra when you take the money personally.
The tax rate on a small Canadian corporation is about 22%, which is about the same as the lowest personal tax rate on incomes under $37,000/year. If your personal taxable income is not over $37,000, then there is not really an advantage of having a corporation.
The profit in a corporation is taxed at a low rate, but you will need to pay it out to yourself one day. Your corporate income can be paid to you as a salary (or bonus or management fee) or as a dividend. If you pay it as a salary, then your business gets a deduction that eliminates the corporation tax on that amount and means you are taxed on it personally.
Have you ever wondered why a dividend is grossed up by 45% on your personal tax return and you then get a 19% credit? What does all this do? The purpose is to put yourself into the same position whether the income was in your business or taxed personally.
If you pay yourself a dividend, then your corporation does not get a deduction, so it has to pay tax on that amount of income. When you gross up your dividend by 45%, this is supposed to approximate the income of your corporation on the dividend before tax. Then the dividend tax credit is supposed to approximate the income your corporation paid.
In short, whether you pay yourself a salary or a dividend, the total tax paid by you and your corporation will be about the same as it would be if you were not incorporated.
There are some planning opportunities in that you can pay yourself an optimal amount (whatever amount you want each year) and you can create another small deferral of tax by one year by choosing the best year-end for your corporation.
The main advantage, however, is if your business makes a profit and you don’t need the money. Therefore, you can leave the profit in the company – either to reinvest in your business or buy investments in the company (or a holding company). The longer you can leave it there, the better. Once you pay it to yourself, the tax advantage disappears.
3. Sell your business:
If you sell your business one day for $500,000 (or $1 million if you spouse owns half), this amount will be tax free if your business is a corporation and meets a few rules.
Making your business saleable is an entire topic. If your business is just you and your relationship with your customers/clients, then if is hard for anyone to buy it. But if you expect to be able to sell it one day, then having it as a corporation can save you a lot of tax.
What happens if you are doing the Smith Manoeuvre? How does this affect your decision on whether or not to have your business as a corporation? This will be a future topic.