Advantages of Incorporation – Canadian Tax Lawyer Comments
There are both tax and non-tax reasons for considering the corporate form of business organization.
Tax Advantages of Incorporation
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 $800,000 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 income 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 $500,000 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 11 – 16% on its first $500,000 of taxable income. The percentages of tax differ depending upon which province the corporation is resident in. 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 tax rate is dependent on whether the dividend is an eligible or ineligible dividend, with the range being between 19% and 40% depending on the province.
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 benefit to incorporation of a small business is the ability to claim the $800,000 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. Additionally, there are further rules stating the taxpayer must hold the shares for a period of two years prior to the sale.
Where the shares qualify, the owner can sell them and the first $800,000 of capital gains are exempt from tax. Note that the exemption applies to the individual and not the corporation. Once an owner has claimed $800,000 of capital gains exemption, the exemption is no longer available on a sale of other qualifying shares. If a spouse owns shares of the business the capital gains exemption is effectively doubled.
When the capital gains exemption is calculated, it is reduced by the taxpayer's Cumulative Net Investment Losses (“CNIL”) balance. The CNIL balance is the amount by which the total of all investment expenses exceeds the total of all investment income for all tax years after 1987. The CNIL can be calculated by filling in CRA's form T936 for each year after 1987.
Capital Gains Purification Transactions
The capital gains exemption mentioned above may only be used when certain tests have been met. They are too numerous and technical for this article, however if a corporation does not meet any of these tests, there may still a way to take advantage of the exemption. This involves removing non-qualifying assets (usually cash or investments) from a corporation in order to ensure that the corporation’s asset mix meets the tests. This process is often referred to as the “purification” of the corporation.
Liability protection is generally the main non-tax reason to incorporate, and is the main motivation for many 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/H.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.
Private Pension Plan
Another advantage of incorporating a professional corporation is the ability to set up an Individual Pension Plan for the business owner/shareholders who are also employees of a professional corporation. It is important to begin planning for retirement early in your career by contributing to a private pension plan. A private pension plan can be registered or unregistered with the Ministry of Revenue. An employer’s contribution to the registered pension plan is not a taxable benefit for the employee whereas it is a taxable benefit if employer contributes to an unregistered pension plan for employee.
An Individual Pension Plan has many advantages over an RRSP, and it can be set up for high income earning incorporated professionals to obtain more immediate tax deductibility advantages than compared with an RRSP. An Individual Pension Plan is a registered and defined benefit pension plan. Private Pension Plans have to be created by a corporate employer with the main purpose of “providing periodic payments to individuals after retirement and until death in respect of their service as employees.” Contributions to the Individual Pension Plan are tax-deductible for employer and if the corporate employer borrowed money to sponsor the contributions for the Individual Pension Plan, the interest can be deducted as well. Because it is a defined contribution plan, it generally will allow the contribution room to increase as a person ages.
There are limits to making contributions to an Individual Pension Plan, as the actual calculation of allowable contribution to an Individual Pension Plan is based on an individual’s age, employment earnings and a formula prescribed by the Canada Revenue Agency (CRA). Due to these factors, larger contributions to an Individual Pension Plan will likely be required as the individual gets older, since the expected time to retirement is shorter. Tax deductible contributions for past services can also be made. In addition, if the pension plan portfolio underperforms (meaning that if the return is less than 7.5% per annum), then the employer must contribute more to the pension plan. Earnings of the pension plan fund are not taxed while they are still in the pension plan. However, the assets of the Individual Pension Plan fund are locked in until retirement; this means that they cannot be withdrawn before retirement.
If the employee no longer works for the corporate sponsor of the employee’s Individual Pension Plan, or if the plan is terminated before the employee retires or turns 71 years old, then the plan must be transferred into a Locked-In Retirement Account or a locked-in RRSP account. No more contributions to the plan can be made and no cash can be withdrawn from it if it is transferred to a Locked-In Retirement Account or a locked-in RRSP account. Any gains that accumulate in the Locked-In Retirement Account and a locked-in RRSP account will continue to be tax-deferred. At retirement age, or when the employee turns 71 years old, the funds in the Locked-In Retirement Account or a locked-in RRSP account must be converted to a Life Income Fund (LIF), Locked-in Retirement Income Funds (LRIF), or a Registered Retirement Income Fund (RRIF), or used to purchase life annuity.
If you are an owner of a professional corporation, as an employer you will generally need to consult with an actuarial or an accountant to determine the necessary and optimal contribution for employees for a given year. An employer’s contribution to the employee’s Individual Pension Plan is not a taxable benefit for the employee. The cost of establishing and administering an Individual Pension Plan for employees is deductible for the corporate employer as an expense.
Disadvantages of Incorporation
Tax Losses Trapped
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 incurred 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.
Integration of the personal and corporate tax systems has virtually eliminated double taxation with the additions of the gross up, credit calculation and the introduction of the general rate income pool (“GRIP”), which is explained below. Corporate profits from active business income in excess of $500,000 per year are taxed at full corporate rates. With full integration, these amounts are no longer subject to double taxation as explained below.
Eligible and Ineligible Dividends
Eligible dividends are taxed at a reduced federal rate, where ineligible dividends are taxed at the full federal rate because these types of dividends are issued from profits earned and taxed at the small business deduction rate. Therefore there is no resulting double taxation.
For CCPC's (“Canadian Controlled Private Corporation”), an eligible dividend is a dividend that is paid out of the corporation's general rate income pool. The GRIP account balance generally reflects taxable income that has not benefited from the small business deduction or any other special tax rate. This eligible dividend designation is at the discretion of the company paying the dividend. It should be noted that the GRIP balance must be sufficient for the dividend to be deemed eligible.
For non-CCPC's the situation is the opposite. All dividends will be eligible dividends unless the corporation has a 'low rate income pool' (LRIP). The LRIP is generally made up of taxable income that has benefited from certain preferential tax rates. An important difference is that these non-CCPC's do not have discretion as to whether the dividend is eligible or not. The LRIP balance must be paid out first as an ineligible dividend before eligible dividends can be paid.
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 section 85 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.
Canadian Tax Lawyer Assistance
If you are looking at the benefits of incorporating your business or are looking for the best method to compensate your employees or shareholders, give our Canadian tax lawyers a call. Effective income tax planning is required to ensure you and your corporation keep as much of the profits as you are entitled to.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."