Incorporating your business can unlock massive tax deferrals if done correctly. Done too early and only additional accounting and legal fees have been unlocked. The most common advice people seem to be told is that at some magic dollar amount, incorporation is the obvious choice. The magic dollar amount seems to change, but the overall spirit has stood the test of time it would seem. Tell me if you’ve heard this before, “..don’t incorporate until you’ve reached $100K of income” or “…at $150K of income, you need to incorporate”, and so on. I’m here to tell you that this is awful advice and is not at all true.
I’ve advised clients who only make $40K of income to incorporate; and conversely, I’ve advised clients with $300K of profit that incorporating will not help them at all! This is because profit, alone, is not the determining factor in whether incorporating will result in tax deferral. You don’t need to believe me, I’ll explain how it works, and you will see for yourself. Please continue to read…
The perceived benefits of incorporation:
- Limited liability:
- Yes, there is some limiting of liability; however, if liability protection is what you’re after, you are probably better served by getting insurance, than incorporating
- Tax savings
- Tax savings is possible, but its not a given. Circumstances have to be present.
- Income splitting
- Absolutely possible, assuming you have someone to split income with and they aren’t already at a high level of tax
- Tax deferral
- This is the most common reason to incorporate and is explained further below.
Corporate income taxes are currently under 14% in BC, for active business income. That’s a very attractive tax rate, and it’s no wonder people are intrigued at paying such a low rate compared to a personal tax rate north of 45%. However, what you have to remember is that after the corporation pays the taxes on its profit, the cash is owned by the Corporation; not by you. If you end up taking that cash out of the company (either as a dividend or salary), you will pay the remaining taxes to get you back to the 45%+ tax rate.
Compare these two scenarios where Person A earns $100K (all tax rates are estimates, used for illustration purposes only):
Person A personally earns $100K and pays 45% taxes. Person A is left with $55K after tax.
Person A incorporates and the corporation earns a profit of $100K. The Corporation pays 15% tax. The Corporation is left with $85K after tax (sounds good so far). Later, the shareholder, Person A, takes that $85K as a dividend and pays the resulting personal taxes. Person A is, again, left with $55K after tax.
As you can see from the illustrations above, regardless of the level of income in the corporation, if the person controlling the corporation drains the corporation of all its profits, there is no tax advantage in having a corporation. Further to my point at the beginning of this article, if you are making $100K, or $500K, and you need all those funds to finance your personal consumption, incorporating will not result in a tax deferral.
The real determining factor in determining whether it is right to incorporate or not, is how much money are you able to save. And more specifically, how much can you save/leave inside the corporation.
In the two scenarios above, Person A earns $100K and required all the remaining cash for their personal consumption. Imagine if they only needed, say $40,000 of this $100K for their personal consumption.
Compare these two scenarios where Person A earns $100K, but only needs $40K:
Person A incorporates and the corporation earns a profit of $100K. The Corporation pays 15% tax. The Corporation is left with $85K after tax. Person A would need to take $60K out of the corporation, pay personal taxes and be left with the $40K they need personally. This leaves $25K in the corporation available for expansion/savings/investing.
Now, I don’t think it takes an accounting designation to tell which scenario is better. I know I’d rather have $25K to invest, than to have $15K. Your can invest more, make more, and compound quicker.
Now, let’s remember, that $25K isn’t all yours. You will eventually have to pay tax on it when you take it out. However, you get to defer this tax until you need the funds personally. In effect, you are using these future tax dollars to invest and make you money. In the above example, $10K of tax was being deferred in one year! Do that 10 years in a row and you are deferring some serious taxes, making money that is earmarked for the CRA, work for you.
As with most tax advice, your personal circumstances will ultimately determine if incorporating can result in a beneficial result or not. I encourage you to speak with an accounting professional to determine if incorporating is right for you or not. The tax pros at BBA Accounting group would be happy to discuss this with you! Give us a call.
Other potential considerations:
- Income splitting
- Salary vs. dividends (CPP?)
- Reinvestment of profits into the business is required