Consideration In Incorporating A Business

This memo provides an overview of the key factors to consider when deciding whether to incorporate a business. It also outlines the advantages and disadvantages of incorporation, with a focus on tax, accounting, legal, administrative, and strategic considerations relevant to business owners.

Key Concepts

A corporation is a separate legal entity, distinct from its shareholders. This separation means the corporation can earn income, own property, enter into contracts and incur liabilities independently of its shareholders.

A key non-tax benefit of incorporation is limited liability – shareholders are generally only at risk for the amount they have invested in the corporation. However, the corporation’s directors may still face personal liability in certain situations, such as failure to remit payroll source deductions or GST/HST. Shareholders of the corporation may also be liable for the corporation’s tax liabilities if they or family members have received property or dividends from the corporation at a time when the corporation has an unpaid tax liability.

General Taxation and Tax Planning

Corporate Tax Rates

Corporations generally benefit from lower corporate tax rates as compared to personal tax rates. In particular, Canadian-controlled private corporations (“CCPCs”) are entitled to a lower corporate tax rate on the first $500,000 of active business income annually, through the “small business deduction” (“SBD”). This can result in a significantly lower corporate tax rate compared to personal income tax rates.

In Ontario and Quebec, this lower corporate tax rate is 12.2% (federal and provincial combined). To the extent a corporation’s active business income for a year exceeds $500,000, or if its entitlement to the SBD has been otherwise restricted, the excess is subject to a corporate tax rate of 26.5% in Ontario and Quebec (federal and provincial combined).

It should be noted that there are federal rules which may restrict a corporation’s entitlement to the lower corporate tax rate, while Quebec imposes additional restrictions for provincial tax purposes. The SBD must be shared by a group of “associated” corporations, such that a corporate group will

generally only be allowed access to the lower corporate tax rate on up to $500,000 of active business income for the corporate group as a whole. It should also be noted that carrying on a business through a corporation does not allow for increased or expanded deductibility of expenses. Regardless of the structure of a business, expenditures are generally only deductible if they are incurred for purposes of earning income and the amount is reasonable in the circumstances.

The lower corporate tax rates relative to personal tax rates provide an opportunity for a significant tax deferral. If the business generates more income than the shareholders require for personal use, surplus funds can be retained in the corporation (or in another corporation, such as an investment holding company). Since personal tax is only triggered when funds are withdrawn as salary or dividends, leaving after-tax corporate profits to be invested at the corporate level provides additional capital to be invested until such time as the shareholders require funds for personal use.

Shareholder Remuneration Planning

Operating a business through a corporation also provides the shareholders with the flexibility to optimize their personal income levels on an annual basis, as well as to determine the optimal mix of compensation between salary and dividends. It is therefore possible to manage one’s personal cashflow needs with their strategies for CPP benefits in retirement, RRSP contribution planning, or optimizing the use of certain personal tax credits and deductions.

Income splitting with family members may be possible by paying dividends to family members (either as direct shareholders, or as beneficiaries of a trust that holds shares of the corporation), which may be taxed at those family members’ lower marginal personal tax rates. However, there are rules that restrict the ability to split income with family members, and these must be considered based on the facts of each situation.

Sale of Business Planning

Operating a business through a corporation may provide significant tax savings on the sale of the business. Each individual resident in Canada is entitled to a capital gains deduction that effectively allows for up to $1,275,000 of tax-free capital gains from the sale of shares of a CCPC that meets certain criteria. The personal tax savings from this capital gains deduction can be up to approximately $340,000 where the full capital gains deduction can be used.

In addition, the ownership of a corporation can be structured to allow for the capital gain on a sale to be shared among family members, potentially allowing a family access to multiple capital gains deductions on a sale of the business, or the reduction of tax by sharing taxable capital gains with family members in lower tax brackets.

Note that the capital gains deduction is only available where shares of a qualifying CCPC are sold – it is not available where an unincorporated business is sold, or where a corporation itself sells the underlying assets of the business.

Estate and Succession Planning

Incorporation can facilitate estate and succession planning. The ownership structure of a corporation can be restructured to implement an estate freeze, where the value of one’s direct ownership in the corporation may be frozen to allow for growth in value to accrue to other family members or to a trust for their benefit. This may allow for the deferral of tax on one’s death, while still retaining control over the corporation and its shares.

Through proper Will planning, incorporation may also facilitate the avoidance of the Ontario Estate Administration Tax (i.e., probate fees) in respect of the value of the underlying business on one’s death.

Creditor Protection and Asset Planning

Incorporation can provide a measure of asset protection, as creditors of the corporation generally cannot access shareholders’ personal assets to satisfy corporate liabilities. Similar asset protection can be provided by transferring after-tax profits from an operating company to a holding company by way of dividends.

Administration

Operating a business through a corporation introduces additional administrative costs and complexity. The process of incorporating and maintaining a corporation involves increased accounting and legal fees compared to an unincorporated business, both in the incorporation process and on an ongoing basis. In addition, corporations must maintain corporate records and comply with annual tax and legal filing requirements. These costs should be considered in deciding whether the benefits of incorporation are worthwhile.

Other Considerations

Employee compensation

A corporate structure may provide additional flexibility in structuring employee compensation by providing equity compensation to key employees through an employee stock option plan. Employee stock option plans allow for favourable tax treatment to employees and may be an attractive employee retention tool.

Losses

Where a corporation incurs losses, those losses may be carried back or forward to other taxation years but can only be applied against that corporation’s income in those other years. Accordingly, where a business is expected to incur losses in the beginning, consideration could be given to operating the business personally as a sole proprietorship or partnership initially so as to allow for the use of those losses against any personal income from other sources. It would be possible to transfer the business assets to a corporation at a later date once the business activity begins to be profitable, although the professional fees to do so would likely be higher than if the business were incorporated at the start.:

Conclusion

Incorporation of a business offers significant potential benefits, particularly in terms of tax, estate and succession planning, and asset protection. However, these advantages must be weighed against the increased complexity, costs, and compliance obligations. The decision to incorporate should be based on the specific circumstances of the business and the owner’s personal and financial objectives.

Contact your Welch LLP advisor if you would like to discuss the appropriate structure for your business or if you require assistance in restructuring your business affairs.