Last updated: Jun. 3, 2021
When it comes to tax planning for Canadian small business owners, it might make sense to incorporate your business.
As a Canadian business owner, you should be looking for ways to minimize your tax burden and maximize your after-tax income. Incorporating a business can do just that.
The primary tax advantages of incorporating your small business include:
- Limited liability
- Lower tax rates
- Income tax deferral
- Lifetime capital gains exemption
- Income splitting
Depending on what your business does and which province you operate in, incorporating can lead to lower taxes. Once the business is profitable, incorporating can also save you money.
When you start a business, it can be structured in 3 ways:
- Sole proprietor
Understanding the advantages and disadvantages of each will help you decide if incorporation is right for your small business.
This is the most basic business structure. One person owns the business and makes all the decisions, keeps all the profits and assumes the risks of the business.
As a sole proprietor, the Canada Revenue Agency views the business and owner/operator as being one and the same, which means you are personally liable for the business. This means if a creditor files a claim against the business, they can go after your assets – whether it’s business or personal.
As a sole proprietor, income is taxed at your personal rate. If the business is having a bad year, you can deduct the losses from your personal income, which lowers your tax bracket.
A partnership is a non-incorporated business that is formed between two or more people. You and your business partner(s) choose how to divide the profits and are equally liable for debts or legal action taken against the business.
Like a sole proprietorship, a partnership has no legal structure. However, it’s recommended partners have an agreement that stipulates how the business is structured, with regards to revenue, profits, expenses and liabilities. This is beneficial come tax time, as each partner understands what percentage of income and expenses applies to them.
On the tax front, a partnership does not file a tax return or pay income tax. Instead, like a sole proprietorship, there is no legal difference between you and the business. As a result, each partner is responsible for filing their own income tax return and claiming the agreed upon share of the partnership’s profits or losses.
Unlike a sole proprietorship or partnership structure, a corporation is its own legal entity that in most cases provides the owners protection from liability.
It also carries the advantage of lower tax rates which can save you a lot of money. There can be higher administrative costs due to set up fees, more paperwork, or the need to enlist the help of professionals to handle more complex tax filing requirements.
Evaluating your business and personal goals against the costs, both financial and investment of time, can help you decide if this structure fits your needs.
An experienced tax professional will be able to help you determine which is right for your small business.
Benefits of Incorporating
Small business owners tend to incorporate because it allows them to access tax benefits that are not available to unincorporated businesses, including income tax splitting, taking advantage of low corporate tax rates, income tax deferral and capital gains exemptions should you sell the business.
These benefits can help small business owners save hundreds or thousands of dollars every year.
The most important benefit of incorporation is the protection it provides by limiting the personal liability of the owners, or what they are responsible for under the law. Since a corporation is its own legal entity, it pays taxes, incurs debt and can be even be sued. However, in most cases, your personal assets are protected against creditors or if legal action is taken against the business (talk to a tax professional about exceptions).
The liability of the corporation does not extend to you personally. This means it can help shield you and – by extension – your family from financial harm.
Lower Tax Rates
As a small business owner, you want to take advantage of as many tax benefits as possible. Incorporating a business allows you to be taxed at a lower rate compared to the tax rate for individuals.
Businesses that operate as sole-proprietorships or partnerships generally pay a higher personal income tax rate on profits as opposed to incorporated business.
For example, if your income hits $250,000, your personal tax rate might average out to 33% federally. The federal tax rate for incorporated businesses is 15% and could be as low as 9%. Applicable provincial tax rates would also apply.
As a incorporated business, you have the benefit of the small business deduction which reduces the corporate income tax that you would have to pay in a taxation year. The reduced rate is available on active business income up to the corporation’s business limit for the year. Currently, the federal business limit is set at $500,000.
Income Tax Deferral
If you do not need to withdraw all the income that your business earns for your personal use, you can defer personal taxation on that income by leaving it in the corporation until it is required. The tax deferral is the period in which the funds are left in the corporation.
Surplus profit can be reinvested back into the business or used for other investments, allowing you to defer personal taxes on withdrawals.
Lifetime Capital Gains Exemption (LCGE)
One of the biggest tax advantages to incorporating comes when it’s time to sell the business.
When you sell a corporation, you are selling an independent entity with its assets and liabilities. If you sell an unincorporated business, you’re personally selling the property and assets.
When you make a profit from the sale of the incorporated business, the Lifetime Capital Gains exemption (LCGE) could save you on paying taxes on all or part of the profits from the sale. For a corporation, the 2020 capital-gains tax exemption limit is $883,384 and increases to $892,218 for the 2021 tax year. Farmers are eligible for a $1 million exemption.
Here’s an example:
You sell shares of your incorporated small business in 2020 and make a $925,000 profit (the profit is referred to as capital gains). Without the LCGE, you would have to pay taxes on half of this amount, i.e., $475,000. Since the LCGE allows you to subtract $883,384 from your profits, you will only pay taxes on the difference – ($925,000 – $883,384) x 50% = $20,808 .
Without the LCGE, you’d be paying tax on the $475,000.
The LCGE is not a one-time exemption. It has a cumulative lifetime limit, so you can continue to use the exemption until you reach the limit.
Many small business owners incorporate their business for this tax advantage alone.
If your business is incorporated, you can pay dividends to your spouse and children. This strategy offers great flexibility to an incorporated business since the dividends paid can vary from year to year, as can the recipients receiving them. This decision will be based on how much income you want to distribute to lower your tax bracket.
You must first set up your incorporated business to include your spouse and/or children as shareholders. Note, this doesn’t have to be done at inception of the corporation as you can amend shareholders throughout the year – remember to update your minute book to reflect the changes. You are then permitted to distribute dividends between family members to reduce your tax burden.
Note: shareholders do not have to employees to receive dividends. But employees can be shareholders and receive both a salary and dividends through the business.
There are additional income splitting strategies available to Canadian taxpayers but you should consult with a tax professional to ensure it’s right for your situation.
Free Download: The Ultimate Guide to Incorporated Small Business in Canada
Many incorporated business owners feel intimidated by the demands of tax season and the corporate filing requirements of the Canada Revenue Agency (CRA). This is completely natural.
While there are numerous benefits to incorporation, it also comes with complex obligations. The complexity and administrative burden of these requirements leave many businesses struggling to keep up.
That’s why we’ve created “The Ultimate Guide to Incorporated Small Business in Canada“. Not only will it help you get organized for tax season, but it will help you make sense of your obligations under a corporate structure and to take advantage of the benefits!
Need help with corporate filing obligations?
For more than 65 years, we have worked with tens of thousands of farm and small business owners across Canada. We optimize their tax returns, maximize their tax savings and support their back office needs with bookkeeping and payroll. Our legal services including minute book filing and annual returns.
To find out more about how we can support your business, take 15 minutes to connect with us so we can get to know each other. Request a consultation here.