Why Incorporate?
There are a number of significant advantages to incorporating a business, rather than operating as a sole proprietor or a partnership.
1. Opportunities to Save and Defer Tax
The corporation and the individual are two separate taxpayers and are taxed at different rates.
2. Increased Opportunities for Income Splitting with your Family Members
Income earned by the corporation may be paid out to persons other than the proprietor by paying reasonable salary and/or dividends to family members.
3. Limited Liability
As a corporation is a separate legal entity, in the absence of personal guarantees only the assets of the corporation can be used to pay its creditors. If an unincorporated business runs into difficulties, paying off its debts could consume all the assets of its owners.
4. Opportunities to Shelter Capital Gains on the Sale of Shares of the Corporation
When selling shares of a “qualified small business corporation” it may be possible to use the capital gains exemption so that up to $750,000 of the sale proceeds per shareholder are not taxed. While the definition of a qualified small business corporation is quite stringent, in general the shares of a corporation engaged in an active business should qualify as long as the corporation has not accumulated substantial non-active business / investment assets (each corporation must be reviewed in detail to determine this). If substantial non-active business assets have been accumulated there are methods available to “purify” the corporation so that it does qualify.
Tax Rates
The main benefit of incorporation is the potential for both saving and deferring tax as a result of tax rate differentials.
Tax savings are achieved when dividends are paid to shareholders having little or no other income, who could use the funds to pay for family lifestyle expenses. The amount of tax saved results from the difference spread between the lower and highest personal income tax rates. If a spouse or adult family member is a shareholder, directly or indirectly (through a family trust), each such shareholder could receive approximately $35,000 in dividends in 2007 free of personal tax (other than the $450 Ontario Health Tax), if they had no other source of income. This creates a tax saving of approximately $11,000 per person, assuming the “proprietor’s” taxable income is over $120,887.
If the shareholders’ lifestyles do not require all of the income produced by the business, cash can be kept in the business and invested thereby deferring the second (personal) level of tax until the cash is paid to the shareholder. The amount of tax deferred depends on the difference between the corporate tax rate on income up to the corporation’s small business limit and the individual’s personal tax rate.
The tax rates for 2009 in Ontario are as follows:
- Top personal income tax rate – 46.41%
- Corporate tax rate up to the first $400,000 of active business income – 18.62%
Relationship between the Individual and the Corporation
Once a business has been incorporated, the role of the individual changes. Instead of being self-employed, the individual is now an employee and also likely a shareholder and a director of the corporation.
Every corporation requires a board of directors. The shareholders of the corporation must appoint at least one director. The director does not have to be a shareholder. Directors may be personally liable for GST and payroll deductions collected by the company and not remitted to the Canada Revenue Agency, for environmental damage caused by the company, etc. Directors are required to demonstrate that they have done their best to prevent the unpaid amounts (such as CPP, EI, Tax, etc) from occurring; simple ignorance of the events is not a sufficient defense.
It is often advisable for the spouse who is the director to limit their ownership of family assets. We do not recommend both spouses being directors. You should discuss this further with us and your legal lawyers.
Anyone can be a shareholder of the corporation. All shares must be purchased at their fair market value in order to avoid adverse tax consequences. A shareholder’s liability to the corporation’s creditors is limited to the shareholder’s investment.
Shares of the corporation may be purchased and owned either directly by family members or indirectly through a family trust. Please note that as a result of the recently implemented tax on split income (also termed the “kiddie tax”) a private corporation should generally not pay dividends on shares owned by minors as this income will be taxed at the highest tax rates.
The use of a family trust to own the shares provides several advantages. The use of a family trust should be discussed with us further.
Initial Decisions Regarding Incorporation
1. Where to Incorporate
A business may be incorporated under the Canada Business Corporations Act, the Ontario Business Corporation Act, or one of the other provincial corporation acts. The costs and advantages of incorporating in the different jurisdictions will need to be discussed with your accountant and legal advisor.
2. Corporate Name
Each corporation is assigned a number that it can also use as its name, or one can choose to use a proper name.
Once a business is incorporated, it is critical to ensure that all aspects of the business are conducted through, and in the name of, the corporation and not the individual. This is important to establish the separate existence of the corporation. A failure to adhere to the legal form and substance of the arrangement may lead to a finding that the corporation is carrying on the business as an agent for the individual. This may result in the business income earned by the corporation being taxed in the individual’s hands. The customers of the business, and the general public, must be aware that the corporation, not the individual, is conducting the business.
3. Share Structure
The selection of an appropriate share structure for the corporation can be made only after the individual’s income and other objectives have been reviewed. The structure is dependent on the income splitting strategies to be used (spouse, children, family trust), anticipated future use of the capital gains exemption, creditor-proofing issues, optimizing the small business deduction, which legislation the business was incorporated under, and many other factors.
A corporation may have many different classes of shares with each class having different voting rights, dividend entitlements, rank in the event of dissolution, redemption rights, etc.
4. Timing of Incorporation
If your new business is being started, you should consider if the business should be undertaken by the corporation from the very beginning.
If the business has already been established (either as a sole proprietorship or as a partnership), as part of the incorporation process the assets of the business will need to be transferred to the corporation.
A sole proprietor who transfers his business to a corporation in mid-year will have a deemed year end upon the cessation of the business (at the transfer date) and will not be able to claim capital cost allowance in that year, as he will no longer own any assets. If the capital cost allowance claim is significant, consideration should be given to incorporating immediately after the end of the proprietor’s normal fiscal period.
For individuals in partnerships who are transferring their business to a corporation, care must be taken to time the transfer so that no adverse consequences arise from a negative equity position at the transfer date.
5. Choice of Year End
A new corporation must choose a year-end within 53 weeks of the date of incorporation. There are many factors to consider when selecting a year-end date, including the ability to defer income (bonuses) to shareholders/employees, the business cycle of the corporation, the minimization of administration costs, etc.
Mechanics of Incorporation
1. From a Sole Proprietorship
Sole proprietors should be able to transfer all of the assets of their proprietorship to the corporation on a tax-deferred basis. The corporation will receive the assets at their tax basis to the proprietor. In return, the proprietor may receive a promissory note, or have the corporation assume the sole proprietorship’s liabilities, equal to the tax basis of the assets transferred. Any liabilities in excess of this amount should either remain with the individual personally or be exchanged for a promissory note payable to the corporation by the individual. If the corporation assumes additional debt, the asset transfer will not take place on a tax-deferred basis.
If any work-in-process exists, even if it is usually deferred for tax purposes, it must be included as one of the assets transferred to the corporation (with a tax basis of $nil). Another asset to be considered in the transfer is goodwill. Goodwill usually has a $nil tax basis but, if the individual has made a February 22, 1994 capital gains election or paid for the goodwill, it may have a higher transfer price which can be withdrawn tax-free from the corporation.
A legal agreement for the purchase and sale between the individual and the corporation will be required for the transfers. This agreement will detail the property to be sold and the combination of shares, assumed liabilities and debt taken back as consideration. In order to determine the fair market value of the business, it may be necessary to undertake a formal valuation of the business. To the extent that the assets transferred to the company have a value in excess of their tax basis, shares of the company are usually issued for that excess amount and a special tax election is filed to defer the tax on the transfer.
2. From a Partnership
A tax deferred transfer of assets from a partnership to a corporation is also possible, although more complicated from both a tax and a legal perspective. The method of the transfer will depend on the desired ending business structure. The partnership may be transferred to one corporation owned by all of the former partners or each partner may form their own corporation and the corporations form a partnership. The rollover of partnership interests into individual corporations would allow each partner to have more flexibility. Every partner would not be required to incorporate under such a scenario.
The above comments regarding debt assumption, work-in-process and goodwill in the context of a sole proprietor also apply in the partnership situation.
3. Goods and Services Tax (GST) and Provincial Sales Tax (PST)
Depending on whether or not the entire business is being transferred to the corporation, what type of assets are being transferred and whether or not the individual and the corporation are registered for GST purposes, GST may be payable on the transfer of assets to the corporation. In most instances, a joint election may be filed by the vendor and the purchaser so that no GST will be payable on the supply of the business assets.
You also have to consider the PST issues on the transfer.
Other Issues to Consider
1. Small Business Deduction
The Small Business Deduction is available to a Canadian-controlled private corporation on the first $400,000 in 2007 of “active business income” ($300,000 in 2006).
The corporation will have to share the small business deduction with other associated corporations. Corporations may be associated if they have significant common ownership and control.
Each individual will need to review what other corporate shareholders they and their family members have.
2. Extracting Funds from the Corporation
There are a number of possible ways to extract funds from the corporation:
a) The individual may be paid a salary from the corporation. In determining the salary to be paid consideration should be given to utilizing low personal tax brackets, creating RRSP contribution room, CPP contributions, the timing of payroll remittances vs. personal quarterly installments and the small business deduction available to the corporation.
b) The promissory notes payable to the individual, in exchange for the tax basis of the assets transferred in may be withdrawn from the corporation as a tax-free reduction of the note.
c) Reasonable salaries may be paid to family members for work performed in business.
d) Income may be taxed in the corporation. Later, when the funds are required they may be withdrawn from the corporation as a taxable dividend to the shareholder. The combined corporate and personal tax will approximately equal the tax that would have been paid by the individual if the income had been earned directly. There is a benefit from the deferral of the second level of tax until the dividend is paid.
Generally, if the income of the corporation is above the small business limit, all of the excess income should be withdrawn as salary.
3. Payroll Remittances
As an employee, the individual will receive a salary that is subject to withholdings for income tax, Canada Pension Plan (CPP) contributions and possibly Employment Insurance (EI) contributions.
Payroll remittances will need to be made periodically by the corporation (the exact timing depends on the size and frequency of the payroll). The remittance includes the income taxes withheld on salaries paid and both the employer and employee portions of any CPP and EI amounts. Please note that there is no EI payable on salaries paid to shareholders owning more than 40% of the shares of a corporation. (Also, generally EI is not payable on salaries paid to the spouses of these shareholders). A “tax ruling” may be required on this matter.
As an employer, you also have to consider the Ontario Employment Health Tax (EHT) and Work Place Safety and Insurance Board (WSIB) remittance.
4. Goods and Services Tax (GST)
Just as for an unincorporated business, GST will need to be charged by most corporations on the goods or services it provides. A business with less than $30,000 of sales is not required to register (no tax is charged on sales and no input tax credits permitted for GST incurred).
If a corporation has sales of less than $200,000, they may be eligible to elect to use the “Quick Method.” The corporation would charge 6% GST but only remit to the Canada Revenue Agency 3.3% (4% prior to July 1, 2006) on the first $30,000 of sales and 4.3% (5% prior to July 1, 2006) on the remainder. The business would not be eligible for input tax credits except on capital asset purchases. This option is beneficial when corporations primarily have business expenses with little or no GST paid on them (e.g., salaries).
5. Automobiles and Home Offices
If the individual is required to use an automobile in carrying out their duties as an employee of the corporation, generally, the corporation should not purchase the automobile. In most circumstances, it will be more beneficial for the employee to own their own car and receive an allowance from the corporation. A “reasonable” allowance (based solely on business kilometers driven and reimbursement of expenses such as parking) received by the employee, is not included in income. Proposed amendments to the Income Tax Act may change this general conclusion depending upon the circumstances. A calculation should be done to determine who should purchase the automobile. On the other hand, if you are going to lease the vehicle, the after-tax cash flow may be better if the company leases the vehicle, even with the taxable benefit. Again, we need to review the numbers in each case.
To the extent that the employee’s/shareholder’s home is genuinely used in the business, the corporation may be able to reimburse the employee/shareholder for a portion of their home expenses.
6. Income Tax Installments
Both Federal and Provincial corporate installments are payable monthly. No installments are payable during the corporation’s first fiscal year.
7. Employee Benefits
As a director, the individual will have to consider which benefits the corporation will make available to its employee(s).
Some benefits provided by the corporation to its employees are taxable to the employees. Even so, the benefits are still inexpensive for the employee than if the employee paid for the benefits using after-tax dollars.
Amounts paid by the corporation for a medical benefit’s plan for employees are not considered to be a taxable benefit to the employees. Premiums for the employees’ short-term disability plan, if paid by the corporation, are also not considered a taxable benefit.
Long-term disability premiums should be included in the employees’ taxable income so that any payments received under the plan are not taxable to them. Or, you can structure the plan so that the long-term disability is taxable, allowing the employee to make RRSP contributions.
8. Costs of Incorporation and Reporting Requirements
There are legal and regulatory costs to incorporate the company. There are also annual costs associated with maintaining the corporate minute books, preparing the company’s annual financial statements and preparing the corporate tax returns (both Federal and Provincial).
Please Call Us Today at 905-528-0234 to Discuss Any Concerns You May Have or email Joe at [email protected].
Recent Comments