In January’s article, during our initial exploration into whether incorporation is the most advantageous route for business owners, we briefly looked at the four commonly used business structures – sole proprietorship, partnerships, joint ventures/arrangements, and incorporations. In this month’s article, we look deeper at the advantages of an incorporated business.
When you operate your business as an incorporated company, it is considered a separate legal entity apart from yourself. As such, it provides certain benefits that are not available to sole proprietors, especially in the area of taxes and limited liability. For the purpose of this article, we will focus on the taxation benefit. I recommend you consult with a lawyer specializing in corporate law about the benefits of limited liability.
As a business grows and becomes more profitable, the business owner generally seeks to reduce the amount of tax they must pay in order to maximize profit and retained earnings. In British Columbia, the 2016 highest personal tax bracket was 47.70% on taxable income over $200,000, while in Ontario that rate is even higher, at 53.53% on taxable income over $220,000. Such high personal tax rates make it less than ideal to run a business under a sole proprietorship structure unless every dollar earned in the business is required to maintain a certain personal lifestyle.
However, if your business income as a sole proprietorship is healthy, say $500,000, and your personal lifestyle requires only $200,000, then you should consider incorporating your business, as the $300,000 that is not required to maintain your desired lifestyle can instead be taxed at a corporate rate of only 13% (if your business is a CCPC – see below). In this situation, with the business operating in British Columbia, you would save taxes (or defer taxes) of $104,100.
When you take the remaining $300,000 out of the company you will pay tax personally on those funds. However, with proper timing and careful planning in partnership with an accountant, you may be able to draw this money from the company at a lower rate than you would if you had earned the income as a sole proprietor. Even if you end up at the high personal tax rate when you draw those funds out of the company, you have still benefited by deferring the taxes and allowing the after-tax dollars to work for you in the corporation.
For example, if your company has a loan on the books to assist with operating capital, the lower tax rate allows more funds to be kept in the company to pay down the loan, saving you money in the end. In our example above, you would have had $104,100 more after-tax cash to pay down the loan.
An important note at this juncture is that the small business deduction which provides for the lower tax rate is only available to Canadian Controlled Private Corporations (CCPC). The small business deduction is limited to the first $500,000 of taxable income from active business. A CCPC is a corporation that is not controlled by a public corporation, non-residents, a corporation traded on a designated stock exchange, or any combination of these. For CCPCs, taxable income above $500,000 is taxed at a higher rate – in British Columbia the rate is 26% on active business income. Again, even at this higher tax rate, you can still benefit from the tax deferral versus the sole proprietorship option.
Next month we will explore some of the other financial benefits of incorporation, such as income splitting and capital gains on the sale of the company.
Jonathon (Tug) McGraw, BCOMM, CPA, CA
BDO Canada LLP
Jonathan can be reached at: firstname.lastname@example.org