Incorporation of your business can create a tax nightmare.
Small Canadian Corporations rank high on CRA’s Target List.
Is this you?
First I incomporated and now I am in serious tax trouble.
Now I wonder what the blazes was I thinking… who was it that told me I would be better off?
After reading the following, you may have second thoughts about incorporation and if you should keep on with something that increases risks, responsibilities and costs.
Firstly Incorporation is good for accountants and lawyers. We all make more money. A LOT MORE MONEY.
It is reputed that there are a number of significant advantages to incorporating a business, rather than operating as a sole proprietor or a partnership.
The facts of the matter are that “Incorporation World is fraught with perils.
There are business reasons to incorporate. However if you are doing it for tax savings or less legal liability, you may want to take a second look. In some cases there is more tax and more liabilities. In all cases, you need an accountant and a lawyer to look after your interests.
Incorporation means that you need to know what you are doing and why you are doing it. Incorporation means you are vulnerable to laws you don’t even know about. You better get familiar with the Corporations Act, the responsibilities of Directors, and getting more attention from government agencies, especially the Canada Revenue Agency (CRA).
In general if you can not afford the services of accountants and lawyers on a regular basis, you should avoid incorporation.
Opportunities to Save and Defer Tax
The corporation and the individual are two separate taxpayers and are taxed at different rates.
Sometimes one is higer or lower than the other. But in ALL CASES when you add your taxable beneifts, to your personal income with the corporate income, you pay more in total business and personal tax than if you were not incorporated… in the long run.
You get to pay more for bookkeeping, tax preparation and legal fees.
This is good for the accountants, lawyers and the economy.
Increased Opportunities for Income Splitting with your Family Members
Income earned by the corporation may be paid out to persons other than the proprietor by paying reasonable salary and/or dividends to family members.
Oh… by the way… you can do the same thing without incorporating.
You get to become your own employee and have more expenses and less deductions.
If you don’t set it up that way, CRA will and do it for you. Then you can hire us to fix it. That is good for us.
Being your own employee means that now you have just blown away a reason to incorporate which was to maximize tax deductions, not minimize them. As your own employee you do not get to write stuff off, except for within the limitations of a T2200 form.
You have to learn hundreds of new laws under the corporations act.
Being that you as the director, are ultimately responsible to follow the law… and you get bad advice… too bad…you are still in serious trouble. So make sure you have read the act before you incorporate.
Your accountants and lawyers can advise you on what to do and not to do, but if the advice is bad, it is you who is on the hook, not them.
Limited Liability
As a corporation is a separate legal entity, in the absence of personal guarantees only the assets of the corporation can be used to pay its creditors.
There is always the issue of who is going to loan you money if you are not personally guaranteeing the loan. Why should a lender risk their money if you are going to use the corporation to avoid being personally accountable to the loans.
CRA is excluded there, and as a corporation, you have to advise CRA prior to going bankrupt, so they can go grab your RRSPs and pensions… something you can avoid if you are not incorporated.
And being that your corporation is one of your assets… I guess you can be sued for your assets… Hmmmm it is not sounding safe…
And by the way…. even under corporate bankruptcy, you are obligated to pay the payroll source deductions and GST/HST…
Oh …yeah… you can be personally sued in any case… being incorporated does not protect you from law suits. It is normal to sue both the corp and the directors.
As the director of a corporation, you are legally obligated to do your due dilligence in all areas of your business. Directors can and do regularly get sued.
Indeed incorporation is good for lawyers because now you have more legal expenses than if you were just a sole proprietor.
Understand that you are legally obligated to follow all the laws of the country as a corporation, it is just that there are a lot of laws regarding corporations, that if you don’t know about, you should not be incorporated.
If an unincorporated business runs into difficulties, paying off its debts could consume all the assets of its owners.
Opportunities to Save and Defer Tax
Your first worry should be about making a profit and paying taxes should be your second concern. Too much attention to aggressive tax planning will just be regretted in the long run. Make sure your planning on how to save taxes in case the odds are right and you will have losses.
The corporation and the individual are two separate taxpayers and are taxed at different rates. When you add the two together, you will likely pay more in total taxes.
Depending on your business the corporation has a higher tax rate, as a Small Canadian Controlled Company could pay more tax on the sale of assets.
You could defer taxes for one year by taking a shareholder or special employee loan. However if you do not understand the complex laws around this, you could find yourself with an unmanageable tax debt.
As a general rule, avoid shareholders loans.
Is there Increased Opportunities for Income Splitting with your Family Members?
Yes there is, however they are pretty much the same as what you can do as a sole proprietor.
Income earned by the corporation may be paid out to persons other than the proprietor by paying reasonable salary and/or to family members.
Yes, corporations can pay dividends, but first the corporation has to play tax on the money. And if you are not prepared to hire a high end lawyer and accountant to set this up for you… forget it….
Understand that if you are incorporating for the purpose of saving taxes, you just may be in la la land and you could find out that if the corporation loses money and you received a salary, you are in a net tax loss situation, where you personally pay taxes, when the business has a loss that if you were a sole proprietor, would not owe taxes.
Opportunities to Shelter Capital Gains on the Sale of Shares of the Corporation.
When selling shares of a “qualified small business corporation” it may be possible to use the capital gains exemption so that up to $750,000 of the sale proceeds per shareholder are not taxed.
While the definition of a qualified small business corporation is quite stringent, in general the shares of a corporation engaged in an active business should qualify as long as the corporation has not accumulated substantial non-active business / investment assets (each corporation must be reviewed in detail to determine this). If substantial non-active business assets have been accumulated there are methods available to “purify” the corporation so that it does qualify.
Translation to the above: Sometimes the possible long term tax perk, are ust not the best overall strategy…. And for heavens sake, understand that CRA will fight you for the spoils.
I recommend tax strategies that will not be challenged by CRA and that will not risk an in depth audit by CRA of all your financial affairs. Understand that when you show CRA you are an aggressive tax planner, they know there be a number of other things that you have done that will also come to light.
Relationship between the Individual and the Corporation
Once a business has been incorporated, the role of the individual changes. Instead of being self-employed, the individual may now become their own employee as well as likely a shareholder and a director of the corporation.
Being a director is a serious and risky legal obligation with onerous responsibilities to the government.
Every corporation requires a board of directors. (that could be a total of one director) The shareholder/s (it could be just you) of the corporation must appoint at least one director.
The director does not have to be a shareholder. Directors may (this is highly likely) be personally liable for GST and payroll deductions collected by the company and not remitted to the Canada Revenue Agency.
Directors are also responsible for environmental damage caused by the company, etc.
Directors are usually required to demonstrate that they have done their best to prevent the unpaid amounts (such as CPP, EI, Tax, etc) from occurring; simple ignorance of the events is not a sufficient defense.
It is often advisable for the spouse who is the director to limit their ownership of family assets, or else the corporation will not serve to protect those assets.
We do not recommend both spouses being directors. You should discuss this further with your legal advisers.
Anyone can be a shareholder of the corporation. All shares must be purchased at their fair market value in order to avoid adverse tax consequences.
Being a shareholder also carries a certain risk. A shareholder’s liability to the corporation’s creditors is limited to the shareholder’s investment in that corporation.
Shares of the corporation may be purchased and owned either directly by family members or indirectly through a family trust. Please note that as a result of the recently implemented tax on split income (also termed the “kiddie tax”) a private corporation should generally not pay dividends on shares owned by minors as this income will be taxed at the highest tax rates.
The use of a family trust to own the shares provides several advantages. The use of a family trust also attracts the attention and challenges of CRA. Personally I do not trust trusts. I have just seen too much.
Corporate Name
Each corporation is assigned a number that it can also use as its name, or one can choose to use a proper name.
Once a business is incorporated, it is critical to ensure that all aspects of the business are conducted through, and in the name of, the corporation and not the individual.
This is important to establish the separate existence of the corporation. A failure to adhere to the legal form and substance of the arrangement may lead to a finding that the corporation is carrying on the business as an agent for the individual. This may result in the business income earned by the corporation being taxed in the individual’s hands and losing a ton of tax deductions.
The customers of the business, and the general public, must be aware that the corporation, not the individual, is conducting the business.
Be clear… if you are not knowledgeable about both corporate law and tax law, then you better be able to afford some expensive help.
You better be prepared for a day a week of extra paperwork over being a sole proprietor.
If you are changing from a Sole Proprietorship or a Partnership to a Corporation, consider this.
Sole proprietors may be able to transfer all of the assets of their proprietorship or partnerships to the corporation on a tax-deferred basis. This also may attract challenges from CRA.
The corporation will receive the assets as a capital gain at their tax basis to the proprietor. In return, the proprietor may receive a promissory note, or have the corporation assume the sole proprietorship’s liabilities, equal to the tax basis of the assets transferred. (If there are any.) Understand that this can be happy hunting grounds for CRA.
Any liabilities to the proprietor in excess of the fair market value amount of the assets should either remain with the individual personally or be exchanged for a promissory note payable to the corporation by the individual. If the corporation assumes additional debt, the asset transfer will not take place on a tax-deferred basis. Understand that tax deferred does not mean that you still have to pay taxes on the gains, at some point in time.
If any work-in-process exists, even if it is usually deferred for tax purposes, it must be included as one of the assets transferred to the corporation.
Another asset to be considered in the transfer is goodwill. Goodwill attracts different tax challenges than stock and trade.
A legal agreement for the purchase and sale between the individual and the corporation will be required for the transfers. This agreement will detail the property to be sold and the combination of shares, assumed liabilities and debt taken back as consideration.
In order to determine the fair market value of the business, it may be necessary to undertake a formal valuation of the business. If CRA comes calling you will need to get and pay for a formal evaluation.
To the extent that the assets transferred to the company have a value in excess of their tax basis, shares of the company are usually issued for that excess amount and a special tax election is filed to defer the tax on the transfer. Note “special” means special extra costs.
Changing From a Partnership to a Corporation
A tax deferred transfer of assets from a partnership to a corporation is more complicated from both a tax and a legal perspective.
The partnership may be transferred to one corporation owned by all of the former partners or each partner may form their own corporation and the corporations form a partnership.
Goods and Services Tax (GST) and Provincial Sales Tax (PST)
Depending on whether or not the entire business is being transferred to the corporation, what type of assets are being transferred and whether or not the individual and the corporation are registered for GST purposes, GST may be payable on the transfer of assets to the corporation.
In most instances, a joint election may be filed by the vendor and the purchaser so that no GST will be payable on the supply of the business assets.
You also have to consider the PST issues on the transfer.
There are lots of other issues to consider
Generally, if the income of the corporation is above the small business limit, all of the excess income should be withdrawn as salary, (at your highest tax rate.)
If you have not realized that the decision to incorporate is a very serious and risky business, by now, then at least understand;
Incorporation is not for the ill informed, or for people who can not afford or are unwilling to pay for expensive help, and the ongoing extra costs of doing business