LAST week, we talked about the different options available to people who are starting or running a business. These included sole proprietorship and partnership, where the owner(s) and the business are the same entity for tax purposes. Profit or loss of the business appear directly on the individual personal tax returns of the owner(s).
Corporation is the third option, and the one generally chosen by businesses that are larger or longer established.
A corporation is a separate entity from the shareholder (or president, director or manager). The corporation files its own tax return and pays tax on any positive net income at the corporate rate that applies to that corporation.
A non-tax advantage to operating a business through a corporation is that the shareholders -- the actual owners of the entity -- are shielded from direct liability for the debts of the corporation or claims against it. While the corporate directors can be held liable for unpaid tax withholdings and certain other statutory items (and they would normally be named in lawsuits against the corporation), generally the corporation itself is the only entity liable for debts or obligations incurred in its name.
For profitable businesses, there are also tax benefits to incorporate. The first $400,000 of profit each year ($500,000 in provinces other than Manitoba) is taxed at the small business rate. Manitoba's is among the lowest in the country, at less than 12 per cent.
For profitable businesses, this low tax rate strongly encourages the decision to incorporate, especially when the profits can be left in the business, rather than all paid out to the shareholders.
For example, if the corporation earns a $200,000 net profit and the shareholder needs $100,000 of salary to cover personal expenses and savings, then $100,000 can be left behind to be taxed at 12 per cent, compared to the personal rate of about 44 to 46 per cent. This means $12,000 of corporate tax and $88,000 to invest, instead of $46,000 of personal tax paid on salary, with only $54,000 to invest, or about $64,000 if $20,000 is contributed to an RRSP.
Some business owners use this as a second RRSP, and some forgo salary and RRSP contributions completely, letting the corporation pay all of the tax and simply withdrawing a dividend adequate to cover personal expenses.
If this business has shareholders in a low tax bracket (who must be 18 or older if related to the primary owner), then a tax saving can be achieved by paying dividends to the lower bracket shareholders, since dividends are taxed at a lower rate than salary or bonus.
The corporation can invest that retained after-tax profit in the active business, or invest it long term for the shareholder's retirement. Such long-term investing, however, must be done strategically and in accordance with tax rules governing corporations. That usually means accumulating money separate corporation, called the holding company.
This allows the active business corporation to qualify as a "CCPC" -- a Canadian Controlled Private Corporation -- in order for the shares to qualify for the lifetime capital gains deduction on a future sale. Rules require the corporation to use 90 per cent or more of its assets in the active business (as opposed to passive investments), carry out business primarily in Canada, and the shares must be owned at least two years by the selling shareholder at the time of sale.
All Canadian taxpayers qualify for a deduction on capital gains incurred when they personally sell shares in a qualified small-business corporation, qualified farm corporation or property and qualified fishing property. Since this can shelter up to $750,000 of gross gain ($800,000 in 2014 and beyond), it's worth some effort.
Selling a start-up business down the road for $800,000 will mean zero tax if the business qualifies, compared with some $185,000 of tax if the gain is taxable.
If you own a corporation carrying on an active business and you are concerned about qualifying, ask your accountant or send me an email with your particulars.
There is a lot more to say about corporations, but next week we will likely take a break and talk about how to take money out of a Registered Education Savings Plan. I understand there is a lot of confusion around this.
In the meantime, stay warm!
Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
David Christianson, BA, CFP, R.F.P., TEP, is a financial planner and advisor with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.