The Pros and Cons of Incorporation Tax: A Comprehensive Guide
What is Incorporation?
Incorporation is the process of creating a corporation which is a separate entity from its owners. In Canada when you incorporate a business it gets legal recognition and can own assets, enter into contracts, sue and be sued in its name. This structure provides a framework that can protect the business owners personal assets and more. The concept of incorporation is based on the need to create a wall between the owners and the business, a separation that isn’t available to sole proprietors or partnerships.
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What to know about Incorporation
Incorporation is not just about creating a new legal entity though; it’s about creating a structure that can grow, attract investment and survive beyond the involvement of its original owners. A corporation can exist forever as long as it meets its legal and financial obligations. This perpetual existence is one of the reasons why incorporation is attractive for long term business plans. Also a business can continue to operate even if the original owners want to step away, retire or sell their shares.
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Types of Corporations in Canada
There are different types of corporations in Canada:
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Private Corporations: These are the most common type where shares of incorporated company are held privately and not traded on public markets. Small to medium sized businesses usually choose this structure.
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Public Corporations: These are larger corporations with shares available to the public on stock exchanges. Public corporations are subject to more reporting and regulatory requirements.
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Non-Profit Corporations: These are entities that operate for charitable, educational, religious or other non-commercial purposes. Profits must be reinvested into the organization and not distributed to members or shareholders.
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Professional Corporations: Some professions such as doctors, lawyers and accountants can form professional corporations which offer some of the benefits of incorporation while the owners remain personally liable for professional misconduct.
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How Incorporation Protects Business Owners
One of the main reasons business owners incorporate is the protection it offers through limited liability. This means that if the corporation incurs debt or is sued the personal liability of the shareholders is limited and their personal assets (homes, cars, personal bank accounts) are protected from creditors and legal judgments. This protection is not available to sole proprietors or partnerships where the owners are personally liable for all debts and obligations of the business.
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Limited Liability: A Closer Look
Limited liability is key to understanding the benefits of incorporation. In a sole proprietorship or partnership the business and its owner(s) are considered the same entity. If the business can’t pay its debts creditors can go after the owner’s personal assets to satisfy those debts. In a corporation the business is a separate entity and its debts are its own. Shareholders’ liability is usually limited to the amount they have invested in the corporation. This separation gives business owners peace of mind especially in industries where legal claims or financial risks are higher.
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Shareholders in a Corporation
Shareholders are the owners of the corporation and their ownership is represented by shares of stock. These shares can be sold, transferred or inherited and provide flexibility in ownership. Shareholders elect a board of directors to manage the corporation. This separation of ownership and management allows shareholders to benefit from the corporation’s profits without being involved in the day to day operations. Also the corporation can continue to operate smoothly even if the shareholders change.
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​Pros and Cons of Incorporation Tax
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Tax Benefits of Incorporation
One of the biggest reasons to incorporate a business is the tax benefits, such as lower corporate tax rates and tax deferral. Corporate tax rates in Canada are generally lower than personal income tax rates and can save incorporated businesses a lot of taxes. This is especially beneficial for small businesses which can qualify for the small business deduction and reduce the tax rate on the first $500,000 of active business income.
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Corporate Tax Rates vs. Personal Income Tax Rates
In Canada corporate tax rates are often more beneficial than personal income tax rates especially for higher income earners. For example a small business that qualifies for the small business deduction may pay a combined federal and provincial tax rate of around 12% to 15% on the first $500,000 of active business income. Personal income tax rates can be as high as 53% in some provinces for individuals in the highest tax brackets. By leaving income in the corporation business owners can defer personal taxes until they take the money out potentially at a lower rate.
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Income Splitting: A Tax Strategy
Income splitting is another big tax benefit of incorporation. It’s about distributing income among family members in lower tax brackets to reduce the overall tax burden. For example if a spouse or adult child is a shareholder in the corporation they can receive dividends which may be taxed at a lower rate than if the business owner received all the income personally. This strategy requires careful planning and compliance with tax laws especially with the recent changes to the income splitting rules (known as “tax on split income” or TOSI) but can still provide big tax savings.
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Lifetime Capital Gains Exemption
The Lifetime Capital Gains Exemption (LCGE) is a big tax benefit for shareholders of Canadian-controlled private corporations (CCPCs). As of 2024 the LCGE allows individuals to claim an exemption of up to $971,190 on the sale of shares of a qualified small business corporation. This means the first $971,190 of capital gains on the sale of eligible shares can be received tax free. This exemption can save a lot of taxes and is a big reason to incorporate especially for business owners who plan to sell their business in the future.
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Tax Deferral: Another Big Benefit
Incorporation allows business owners to defer personal taxes by leaving profits in the corporation. Instead of paying personal income tax on all the business income earned each year incorporated business owners can leave some of the profits in the corporation where they will be taxed at the lower corporate tax rate. This can be a big cash flow advantage and allow the business to reinvest profits or save for future expenses. When the owners take the money out they will pay personal income tax on the amount taken out but this can be timed to occur in years when their personal income is lower and reduce the overall tax burden.
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Tax implications of Incorporation
While incorporation has many tax benefits it also comes with specific tax obligations and implications that business owners need to be aware of. Corporations in Canada are taxed on their taxable income which includes active business income. The corporate tax rate is applied to this income and the corporation is responsible to pay the tax. Shareholders may also be required to pay tax on dividends received from the corporation.
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Corporate Tax Filing Requirements
Incorporated businesses must file a corporate tax return (T2) annually even if they have no taxable income. The T2 annual corporate tax return is more complex than the personal tax return (T1) and requires detailed financial statements, schedules and supporting documents. Corporations must also file a separate tax return for each province or territory they operate in as provincial corporate tax rates and rules can vary. Failure to file these returns on time can result in penalties and interest charges so it’s important to stay on top of filing deadlines.
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Dividends in Corporate Taxation
Dividends are payments made by a corporation to its shareholders from after tax profits. For shareholders dividends are a way to receive income from the corporation. However dividends are subject to personal income tax although they are eligible for the dividend tax credit which reduces the amount of tax payable. The dividend tax credit is designed to account for the fact that the corporation has already paid tax on its profits but it doesn’t eliminate the any future corporate income tax entirely. This is where the concept of double taxation comes in.
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Double Taxation: A Big Drawback
One of the biggest downsides of incorporation is double taxation. This occurs when the corporation is taxed on its income and then the shareholders are taxed again on the dividends they receive. For example if a corporation earns $100,000 in profits it may pay $15,000 in corporate tax and leave $85,000 to be distributed as dividends. If the shareholder receives the full $85,000 as a dividend they will have to pay personal income tax on that amount potentially at a high rate. This double layer of taxation can result in a higher overall tax liability than being a sole proprietorship or partnership.
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How to Minimize Double Taxation
While double taxation is a concern there are strategies business owners can use to minimize its impact. One approach is to retain earnings within the corporation rather than paying them out as dividends. This allows the corporation to benefit from the lower corporate tax rate and provides additional capital for reinvestment or future expansion. Another strategy is to take a salary instead of dividends. Salaries are deductible expenses for the corporation and only taxed once at the individual’s personal income tax rate.
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Incorporation Complexity and Cost
Incorporating a business is more complex and costly than being a sole proprietorship or partnership. The process of incorporation requires registering the business with federal or provincial authorities, preparing and filing articles of incorporation and paying the fees. In addition to the upfront costs incorporated businesses also have ongoing legal and regulatory requirements such as filing annual returns, maintaining a minute book and holding regular meetings of directors and shareholders.
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Incorporation Cost
The cost of incorporating a business in Canada depends on whether you incorporate federally or provincially. Federal incorporation is $200 to $300 and provincial, incorporation costs is $300 to $400 depending on the province or territory. In addition to the government fees there are also legal and accounting fees to prepare the necessary documents and ensure compliance with corporate law. These professional fees can add several thousand dollars to the cost of incorporation especially if the business structure is complex.
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Ongoing Compliance Costs
Once incorporated businesses must comply with various ongoing legal and regulatory requirements. This includes filing annual returns with the relevant government authority, maintaining corporate records in a minute book and holding annual meetings of shareholders and directors. Failure to comply with these requirements can result in penalties, loss of corporate status or legal challenges. Many businesses choose to hire a lawyer or accountant to help with these tasks adding to the ongoing costs of incorporation.
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Minute Book
A minute book is a vital document for any corporation. It contains the official records of the corporation’s activities including articles of incorporation, bylaws, minutes of meetings, resolutions, share certificates and registers of directors and shareholders. Keeping a minute book up to date is not only a legal requirement but also good corporate governance. In the event of a legal dispute or audit the minute book is the official record of the corporation’s decisions and actions. Not keeping an accurate minute book can result in legal challenges and undermine the corporation’s credibility.
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Raising Capital and Attracting Investors
Incorporated businesses find it easier to raise capital and attract investors than sole proprietorships and partnerships. The corporate structure and limited liability protection makes it more attractive to investors. Corporations can also issue shares to raise capital and give investors a tangible ownership in the business. This ability to raise capital is especially helpful for small businesses looking to grow.
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Investors are more willing to invest in a corporation because of the legal protections and structure. For example, in a corporation investors can buy shares and become part owners of the business. This ownership can be transferred or sold easily which is not possible in a sole proprietorship or partnership. Also because a corporation is a separate legal entity investors risk is limited to the amount they invest. Investing in a corporation is less risky than investing in a sole proprietorship or partnership where personal assets are at stake.
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Share Structure in Raising Capital
The ability to issue different classes of shares is a powerful way to raise capital. Corporations can create multiple classes of shares each with different rights and privileges such as voting rights, dividend rights and rights to assets upon dissolution. This flexibility allows corporations to tailor their offerings to different types of investors. For example a corporation might issue preferred shares with guaranteed dividends to conservative investors and common shares with voting rights to more active investors. This ability to structure investments according to investor preference makes a corporation more attractive to a wider range of investors.
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Equity Financing
Equity financing is raising capital by selling shares in the corporation. This type of financing is useful for start-ups and growing businesses that don’t have the cash flow or credit history to get traditional loans. By issuing shares a corporation can raise a lot of capital without taking on debt. But equity financing means the original owners must share ownership and control of the business with new investors. This trade off between raising capital and retaining control is a key consideration for business owners when deciding to incorporate.
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Debt Financing: An Alternative to Equity Financing
While equity financing is selling ownership in the corporation, debt financing is borrowing money that must be repaid with interest. Debt financing can be bank loans, lines of credit or bonds. For many businesses debt financing is an attractive option because they can raise capital without giving up ownership or control. But debt financing comes with the obligation to make regular payments regardless of the business’s financial performance. Failure to meet these obligations can lead to financial distress or even bankruptcy.
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Make an Informed Decision
Deciding to incorporate is a big decision that requires considering many factors. While incorporation has many benefits such as limited liability protection, tax advantages and easier access to venture capital firms it also comes with increased complexity, higher costs and double taxation. Business owners must weigh these pros and cons according to their situation, goals and risk tolerance.
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Things to Consider Before Incorporating
Before you decide to incorporate:
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Personal Income Tax Rate: If your personal income is in a high tax bracket, incorporating can save you a lot of tax by leaving your business profits in the corporation where they will be taxed at a lower rate.
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Business’s Taxable Income: How much taxable income your business generates is a key consideration. If your business is very profitable, incorporating can reduce your overall tax liability.
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Potential for Growth: If you plan to grow your business, attract investors or raise a lot of capital, incorporating may give you the structure and credibility to achieve your goals.
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Complexity and Cost: Incorporation is more complex and costly than other business structures. Is your business ready to handle these additional costs and extra requirements.
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Risk Tolerance: If your business operates in a high risk industry the limited liability protection of incorporation may be more valuable.
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Get Professional Advice
Given the complexity of incorporation and the tax implications it’s important to get professional advice before you decide. A lawyer can help you navigate the legal requirements of incorporation and a tax accountant can help with the tax implications and financial considerations. They can help you determine if incorporating is right for your business and ensure you comply with all legal and regulatory requirements.
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FAQs
What are the advantages of incorporating in Canada?
Limited liability protection, tax advantages, easier access to capital and perpetual existence. That’s why many business owners incorporate.
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How do I incorporate my business in Canada?
Incorporating your business in Canada means registering your business name, filing articles of incorporation with the federal or provincial government and setting up corporate records including a minute book. You may also need to get business licenses and permits depending on your industry.
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What are the downsides of incorporating a business in Canada?
The main downsides are increased complexity, higher costs and double taxation. Corporations are also subject to more reporting and compliance requirements than other business structures.
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How can I minimize the tax implications?
To minimize the tax implications of incorporation consider income splitting, dividend planning and the Lifetime Capital Gains Exemption. Also make sure to work with a tax professional to ensure you are taking advantage of all the tax deductions and tax credits available.
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Bottom Line: Should You Incorporate?
Incorporation has many benefits such as tax savings, limited liability and easier access to capital. But it also comes with increased complexity, costs and double taxation. By considering the pros and cons, getting professional advice and evaluating your business situation and goals you can make an informed decision.
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