When to incorporate to your tax advantage

Doing so can make sense for a growing business, but not necessarily for personal investments.

Matthew Elder 9 January, 2017 | 6:00PM
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Corporations generally pay income tax at lower rates than individuals, so it's not surprising many owners of small businesses -- as well as high-net-worth investors -- wonder about setting up a corporation to house their affairs.

In many cases, it makes sense to go corporate -- more so in the case of the business proprietor than the investor -- but, as with most tax-related decisions, it depends on specific circumstances.

A key consideration is the initial set-up cost (legal and accounting fees) and the ongoing expense of annual financial-statement preparation and filing corporate tax returns. But, ultimately, what counts is the amount of after-tax income that is received by the business proprietor or the investor as an individual taxpayer.

Here are some things to consider when setting up a corporation for investment purposes or for a small business:

Investment holding company

Income earned by investments -- including interest, dividends and capital gains -- that are held by a corporation are taxed at the same rates as those for individual investors. Thus, normally there is no advantage to setting up an investment holding company.

However, there are some exceptions, says Tom Flaig, a senior manager in the tax practice of EY's Private Client Services group. One is where family members are shareholders of the investment corporation. "It may be possible to ultimately save tax where dividends that trigger a dividend refund can be paid to low-income family members," Flaig says.

Another potentially beneficial situation is to create an estate freeze by transferring investments to a corporation. Flaig says this should be done on a tax-deferred basis, with all future growth of the investments accruing to other family members, such as children.

For example, assume a parent has an investment portfolio with a fair market value of $5 million and an adjusted cost base of $1 million. "The parent could transfer the portfolio to a holding company and elect for the transfer to occur at the cost of the investments, so that that the inherent capital gain of $4 million is deferred," Flaig says.

Through this transfer, the parent receives fixed-value preferred shares with an aggregate redemption value of $5 million (the fair market value of the portfolio). "The common shares of the holding company will be owned by the parent's children, allowing the future growth in the portfolio to accrue to the children," he says.

Dividends from the holding company can be paid to the children -- assuming they are the age of majority and thus won't be subject to anti-avoidance rules, known in this case as the "kiddie tax" -- and trigger a dividend refund to the holding company. Furthermore, Flaig says, the preferred shares held by a parent can be redeemed over time to fund his or her lifestyle, while reducing the overall tax liability realized upon death.

Certain conditions must be met to allow such transfers. Just as for personally held investments, only expenses (such as carrying charges and investment-management fees) that are incurred to earn income are deductible.

Flaig says the following factors should be considered:

  • Are there adult family members in a lower tax bracket who could benefit from corporate dividend income in the future?
  • What is the fair market value and growth potential of the investments to be held in a corporation, and are there estate-planning considerations? Generally, the greater the value and growth potential of the investments, the greater the opportunity to utilize estate-planning opportunities to transition future growth of the investments to the next generation.
  • What are your future and retirement income needs? "For example, investments that generate income beyond an individual's personal/retirement needs may be transferred to a corporation to enhance income-splitting opportunities as well as transition ownership of the investments to the next generation in a tax-efficient manner."

You should discuss the circumstances surrounding each of these considerations with an expert in this taxation area.

Converting a registered business to a corporation

A key reason to incorporate a small business is the ability to defer receipt of personal income, in addition to legal liability issues. (Because a corporation is as separate legal entity, in most cases your personal assets are protected from legal action against the company, including that involving creditors.) Cash left within a corporation will be taxable at the lower corporate rate until you, the business owner, need to receive it for personal use.

Most small businesses that convert to a corporation qualify as a Canadian controlled private corporation, or CCPC. This assumes the majority of shares are owned by a Canadian and/or its shares are not publicly traded. A CCPC pays tax on business income at below 20% on a combined federal/provincial basis, compared with top marginal personal tax rates as high as 50% or more, depending on the province.

"The lower corporate tax rate can leave substantial after-tax dollars in the corporation that can be used to reinvest in the business, reinvest in investment assets or pay off corporate debt at a faster rate," Flaig says.

There is no magic revenue number that signals the need to incorporate a small business. Rather, the decision should be based on whether the business is generating excess cash. In other words, do you as sole proprietor spend everything you earn? Other key issues are income-splitting opportunities (by having your spouse or adult children as shareholders) and estate-planning possibilities.

However, it's worth noting that, by remaining unincorporated, you can continue to use business losses to reduce other sources of income, such as from employment if you are working in addition to running your business. Losses incurred by a corporation can be used only to reduce future business income. Overall, as with an unincorporated business, business expenses can be used only as deductions from business income.

What's more, a corporation brings additional costs in terms of accounting and legal obligations. "Operating a business through a corporation generally carries a greater compliance cost from a legal perspective, as the company will be required to maintain a minute book and file an annual return with the [provincial] corporations branch," Flaig says.

On the plus side, the corporate deferral provides a tax break over the years for funds that remain invested in the company. And there can be an additional break by receiving income from the corporation in the form of dividends, which are taxed more favourably than regular (salary) income.

However, the salary-or-dividends decision is a complex process. "The decision to take a salary or dividend is not necessarily a tax decision," Flaig says. "It must be analyzed on a case-by-case basis."

He identifies a number of additional factors to consider:

  • Dividends are not considered earned income and thus will not contribute to an individual's RRSP contribution limit.
  • Unlike for salary, income tax need not be withheld on dividends for the purposes of income tax, Canada/Quebec Pension Plan or Employment Insurance.
  • Dividends can be paid to family members even if they do not contribute to the business.
  • Salaries are tax-deductible to the company, whereas dividends are not.
  • Dividends are subject to lower personal tax rates.

There is a lot of analysis to do, but it's a valuable process because in many cases setting up a corporation is a worthwhile endeavour in terms of tax savings and legal protection -- not to mention enhancing your business's overall professional image.

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Matthew Elder

Matthew Elder  Former Vice President, Content & Editorial of Morningstar Canada, Matthew was previously an editor and columnist at the Financial Post and The Gazette in Montreal.

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