The tax pros and cons of incorporating your small business in Canada

Why incorporation isn’t always a magical tax fix

Sandie’s wife has a small business she plans to run for the next few years. Is she better off incorporating her business or not?

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Q: My wife and I are looking to retire in about five years or so. I am 55 and she is 52 and we are debt free. My question is: my wife recently started to work for herself designing kitchens and we were wondering tax-wise if it is better to claim this as self-employed income or to open a small business?

Also, what are the CPP rules on self-employed?

—Sandie

A: I think it’s good, Sandie, that you and your wife are considering whether to incorporate rather than just plowing ahead. I find far too many people immediately set up a corporation when they go into business and regret it afterwards. I did it myself when I was young with a hobby business – and regretted it.

From a tax perspective, an unincorporated business that you run generates personal income that goes on your personal tax return. This would be considered a sole proprietorship, or, if you had partners, a partnership.

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There’s a section on your personal tax return to report self-employment income and deduct eligible expenses. The net income – revenue less expenses – gets taxed accordingly.

It’s a common misconception that incorporation somehow gives you access to magical tax deductions that a sole proprietorship does not. That’s not really accurate. The eligible deductions are more or less the same for the purposes of most self-employed people.

Whether you’re a sole proprietor or incorporated, GST/HST sales tax applies if you choose to register voluntarily or if you have more than $30,000 of revenue in a year (technically in four consecutive calendar quarters, whether they all fall in the same calendar year or not).

READ: 7 things to remember when doing this year’s taxes

Incorporation can have its benefits, Sandie. A corporation can look more professional than an unincorporated business and for some potential customers, this can instill confidence. Corporations can also limit the liability of shareholders, providing a degree of protection in businesses that may have liability risks.

A key tax benefit of a corporation is the ability to retain unneeded income and have it taxed at a low tax rate. Rates range from 10% to 18% on the first $500,000 of small business income depending on your province of residence. This compares to personal tax rates that are much higher, particularly for those with high incomes. Given that 7 out of 10 provinces have top tax rates exceeding 50% currently, you can appreciate how corporate tax deferral can be beneficial for some taxpayers, Sandie.

Until this year, corporations also presented the opportunity to split income with family members by making them shareholders and paying them dividends. With the new Tax on Split Income (TOSI) rules that came into effect on January 1, 2018, income splitting probably wouldn’t be a benefit of incorporation unless your wife accumulated savings that she planned to pay out to you after the age of 65.

Of note is that if your wife plans to pay you a salary, whether she was incorporated or not, it would only be tax deductible if it was reasonable based on the work you did for her.

If your wife thought she might be able to sell her business someday, incorporation could give her access to the lifetime capital gains exemption of $848,252. Selling shares of her corporation may result in tax-free income of up to this threshold, depending on several other technical factors.

Now for the drawbacks. Incorporation has costs. Legal fees would typically be at least $1,500 and usually more for even a simple incorporation, Sandie. Then there’s accounting. A corporate tax return would typically cost $1,500 or more each year. And if you’re not doing your own bookkeeping, a bookkeeper would typically charge $30-$60 per hour depending on where you live or if your accountant did the bookkeeping, it would drive up your accounting costs.

Record-keeping also tends to be more onerous, both for tax purposes and for keeping your minute book (legal records) up to date.

MORE: 5 money-saving tax tips for small business owners

The point is, Sandie, make sure the thousands of dollars of costs and extra work are worth it. Many small businesses, especially in the early stages, are better off not incorporating.

You asked about Canada Pension Plan (CPP) rules, Sandie. If you are a sole proprietor, you pay CPP contributions at the applicable rate on your personal tax return, effectively self-remitting the contributions an employer may have otherwise withheld based on your net income. As your own employer, you end up remitting double the contributions though. Typically, an employee remits half and their employer remits the other half. When you’re self-employed, you wear both hats.

If you’re incorporated, CPP contributions will depend on what you take out of the corporation and how. CPP contributions are only payable on salary you pay yourself from the corporation. So, if you retain all the earnings (unlikely), there are no CPP contributions. As an owner-manager of a corporation, you could take your compensation as either salary or dividends. Dividends do not attract CPP contributions, but also don’t build your entitlement to the CPP retirement pension. And salary would require both employee and employer CPP contributions, just like if your wife was a sole proprietor.

So, there you have it, Sandie. It’s hardly an exhaustive assessment of the benefits of incorporation, but hopefully for your purposes and those of many potential small business owners reading this column, it helps.

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Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.