Thought Leadership: The Tax Implications of Incorporation

To incorporate, or not to incorporate? It’s a timely question, considering recent corporate tax reforms. However, it’s also a question that existing business owners and aspiring business builders should think about post tax season as they discuss business growth planning with their tax specialists. It’s an important strategy that can save thousands of dollars that helps build family wealth over the long run.

For many business owners, this is a daunting decision because of the complexity of the tax rules. There are many questions to consider, such as:

• What is the purpose of incorporating?
• What are the tax implications on income, asset acquisitions and dispositions and on owner-manager compensation?
• How do I get my money out of my corporation and into my own hands and that of my family members in the least expensive way?
• What happens when I sell my corporation or start taking a retirement income from it?

Some of these structural questions are well answered in Knowledge Bureau’s new certificate course, Business Law and Contracts which is found in the MFA™-Executive Business Growth Specialist program.  The corporate tax courses available including Corporate Income Tax Fundamentals and Tax Planning for Incorporated Professionals will also help to explain the integration between the personal and corporate tax systems, so that business owners can better plan compensation options now and in retirement.

Here’s a look at some of the issues every business owner should understand when considering incorporation:

• A sole proprietor operates a business as an individual. The business is not a separate legal entity in this case. Products or services are provided by the person who then adds the net business income to all other sources of income in his or her tax return. It is the least costly from the point of view of professional fees payable to an accountant and/or lawyer for incorporation services, but leaves the proprietor open to full liability, and potentially higher tax rates on income.
• A partnership is formed when two or more parties carry on a business together to make a profit. No registration is required. Partners are all equally liable for the partnerships liabilities, and they will report their share of the net partnership income on their individual returns.  
• A corporation is a separate legal entity. It can own assets, borrow money, and enter into contracts. It files a separate tax return to report net and taxable income. Shareholders are generally compensation when dividends are issued, or with salary or wages or benefits, if they are an employee of the firm. 
• Shareowners own the corporation. They are entitled to elect directors, receive dividends, and receive value on appreciation of the assets after the corporation is wound down.
• Directors are the operating mind of the corporation. They sign contracts, make resolutions, and decide to issue dividends.
• Directors can be held personally liable if the corporation fails to remit taxes, sales taxes, employee remittances, or if the corporation breaches federal environmental laws.
• Directors must be wary of conflicts of interests. Corporate laws impose a fiduciary duty so while directors have all the control, every decision must be made in the best interests of the corporation.
• Directors must treat minority shareholders fairly. Otherwise, minority shareholders can apply to court for an oppression remedy. Courts have the power to make any change it sees fit in the circumstances.
• Directors must make reasonable decisions on behalf of the corporation. Perfection is not required.
• A Unanimous Shareowners Agreement restricts the power of directors. It governs the relationship between shareowners and provides mechanisms to resolved fundamental differences.

As you can see, while your day-to-day activities are not much affected by your business structure, your legal liability and your tax obligations are. Treating the planning around the appropriate business structure simply as a “technicality” could lead to unintended consequences, especially as it relates to complicated taxation rules.   

Business owners who make financial decisions throughout the year, for example paying dividends to family members who are inactive shareholders, can doom the personal tax consequences to the expensive new Tax on Split Income rules. In another example, paying dividends rather than salary will be at the expense of making Canada Pension Plan contributions and creating unused RRSP room, which could have implications down the line in retirement planning. Using a Real Wealth Management model, the best decision is to take a multi-stakeholder approach to personal corporate tax planning. 

Tax rates are also significantly different for a corporation versus an unincorporated proprietorship. While an individual must include and pay tax on all profits of the proprietorship at their marginal tax rates, a corporation generally pays a flat rate of tax, depending on source of income.

Active business income earned a corporation that qualifies for the Small Business Deduction will be subject to tax at a lower rate.  But if the passive investment income earned on retained earnings in a company are significant - $50,000 or more - that small business deduction can be clawed back, with the result that higher general tax rates are applied.     

The best way to protect yourself and your business from unintended tax consequences is to understand the legal framework under which businesses operate and what options you have for optimum owner-manager and family tax planning . If you want to learn more, enrol and start online now: completion of the Business Law and Contracts course provides credits towards the MFA™ – Executive Business Growth Specialist program. Or, get a sneak peek by taking a free trial.

Additional educational resources: Hone your leadership skills, and network in the company of fellow business owners at Knowledge Bureau’s second annual Business Builder Retreat. Taking place this November in Puerto Vallarta, Mexico.

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