Tax Benefits and Disadvantages of Incorporating in Canada

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Tax Benefits and Disadvantages of Incorporating in Canada

Sebastien Prost, CPA

There are many benefits and disadvantages of incorporating a business in Canada, both from a legal and tax perspective. When you incorporate, your business becomes its own legal entity, separate from its owners. This distinction provides limited liability protection, meaning that your personal assets are shielded from the business’s debts and legal obligations.

Incorporating can lead to significant tax benefits, allowing you to minimize your tax burden and maximize your after-tax income. In this comprehensive guide, we will explore the tax benefits of incorporating your business in Canada, as well as the potential disadvantages and the factors to consider when deciding to incorporate.

What Does it Mean to Incorporate a Business in Canada?

Incorporating a business in Canada means establishing a separate legal entity distinct from its owners. This process involves registering the business with the appropriate provincial or federal government authorities and adhering to certain legal and administrative requirements.

Moreover, annual meetings are required, where shareholders and directors gather to discuss important matters. Keeping detailed corporate minutes during these meetings is essential for legal compliance. You’ll need to appoint corporate officers, such as a president and secretary, and ensure they fulfill their roles effectively.

Additionally, documenting business ownership is crucial, including the issuance of shares and maintaining a shareholder register. Finally, selecting this type of business structure impacts taxation and liability, so careful consideration is essential for long-term success.

Benefits of Incorporation in Canada

The advantages of a corporation are vast and can greatly benefit your business. First the tax benefits of incorporation with lower tax federal and provincial corporate tax rates allowing for deferral opportunities cannot be understated. Incorporating your business brings with it several advantages, particularly in terms of taxes, liability protection. This also enables you to strategically plan your personal income to minimize overall tax liability.

Furthermore, incorporating provides limited liability protection, separating personal and business assets. It also allows the safeguarding of personal assets from business debts and legal obligations. Incorporation also offers benefits for long-term business planning and succession, potential tax savings, and eligibility for the Lifetime Capital Gains Exemption. However, it is crucial to carefully consider the costs associated with incorporation and seek the guidance of a qualified tax professional or accountant to make an informed decision.

Limited Liability

One of the primary advantages of incorporating your business is limited liability protection. As a sole proprietor or a partnership, you are personally liable for any debts or legal claims against the business. This means that if the business defaults on its debts or faces legal action, your personal assets, such as your house or car, can be at risk.

However, when you incorporate, your personal liability is limited to the amount of money you have invested in the company. Your personal assets are generally protected, and creditors cannot go after them to satisfy business debts or legal claims. This separation between personal and business assets provides a layer of security and peace of mind for business owners.

How to Save Taxes by Incorporating in Canada

Another of the main benefits of incorporating is the significant tax savings and deferral opportunities it can lead to.

Income Tax Saving Due to Lower Rates

The small business tax rate gives you the ability to take advantage of lower corporate tax rates compared to personal tax rates. CCPCs can claim the small business deduction which reduces the federal corporate tax rate to 9%. Generally, the taxes on small business income will be lesser if earned in a corporation vs a sole proprietorship.

As a sole proprietor or partnership, your business income is taxed at your personal tax rate, which can be considerably higher than what you would pay in small business taxes if incorporated. By incorporating, you can potentially reduce your overall income tax liability and retain more of your business income.

Tax Deferral

Earning income through a corporation means more flexibility in how and when you take money out. This flexibility allows you to defer personal taxation on the income by leaving it in the corporation until you need it. By deferring taxes, you can spread out your personal income and take advantage of lower tax rates in the future.

For example, if your business earns $150,000 per year but you only need $80,000 for personal expenses, you can choose to take out only $80,000 from the corporation. This decision can result in lower personal taxes in the current year, and the remaining income can be retained within the corporation for future use or investment.

Salary vs Dividends

By incorporating, you have the option to receive income in the form of dividends. Dividends can sometimes be taxed more favorably compared to employment income due to the dividend tax credit. This can provide additional tax savings for business owners.

Lifetime Capital Gains Exemption (LCGE)

Another of the benefits of incorporating is the potential eligibility for the Lifetime Capital Gain Exemption (LCGE). The LCGE allows business owners to sell shares in a qualified small business and reduce the amount of tax payable. The current limit for the LCGE is $971,190 for the 2023 tax year.

To qualify for the LCGE, certain conditions must be met, including:

  • The shares being sold must be qualified small business corporation shares.
  • The shares must meet the ownership and holding period requirements.
  • The corporation must be a Canadian Controlled Private Corporation (CCPC).
  • The proceeds from the sale must be considered capital gains.

By incorporating your business, you create the opportunity to benefit from the LCGE when you decide to sell the business in the future. This can result in substantial tax savings and increase the overall value of your business.

Income Splitting

Incorporating your business can also provide income splitting opportunities, allowing you to distribute income among family members who are shareholders in the corporation in certain situations. Income splitting can help reduce the overall tax burden by taking advantage of lower tax brackets of family members.

For example, if your spouse or adult children are shareholders in the corporation, you can allocate dividends to them, potentially resulting in lower overall tax liability for the family unit. It’s important to consult with a tax professional to ensure that income splitting strategies comply with tax regulations and are suitable for your specific situation.

Disadvantages of Incorporation in Canada

While there are numerous benefits of incorporating a business in Canada, it’s essential to consider the potential disadvantages too. Incorporation comes with additional costs and administrative requirements that may not be suitable for every business.

Incorporation Costs

One of the first considerations when deciding to incorporate is the upfront cost. Incorporation costs can vary depending on the province and the level of assistance sought. The costs typically include government fees, legal fees, and potentially accounting fees if professional assistance is required. For example, in Ontario, the government fee for incorporation is $300 CAD, while it is $350 CAD in British Columbia (BC). Additional fees also may apply for name searches and registrations.

Ongoing Administrative Burden

Once incorporated, businesses have ongoing administrative obligations that must be fulfilled. These obligations include filing annual corporate tax returns, maintaining proper record-keeping, and complying with government regulations.

The increased administrative burden may require additional time and resources to ensure compliance, such as hiring an accountant or using accounting software.

Losses More Difficult to Use

Incorporating a business can make it more challenging to use business losses to reduce future taxes. Unlike sole proprietorships or partnerships, where losses can be deducted from personal income, corporations may have limitations on the utilization of losses. Losses incurred by the corporation can only be carried forward or backward within certain restrictions, potentially limiting their immediate tax benefits.

Additional Costs

In addition to the incorporation costs, there may be ongoing additional costs associated with maintaining a corporation. These costs can include legal and accounting fees for annual filings, maintaining a minute book, and fulfilling other regulatory requirements. It’s important to budget for these additional costs and consider them as part of the overall financial implications of incorporating.

When Should a Business Incorporate in Canada?

Deciding when to incorporate your business in Canada depends on various factors. This includes but is not limited to the nature of your business, your income level, and your long-term goals. There is no specific income threshold that determines when a business should incorporate. However, it typically becomes more advantageous to do so as your business income exceeds $60,000 annually.

Before making the decision to incorporate, consider the following:

Income Level and Tax Planning

If your business is generating a significant amount of income that exceeds your personal cash needs, incorporation can provide tax planning opportunities. By deferring personal taxation and taking advantage of lower corporate tax rates, you can potentially retain more income within the corporation and strategically plan your personal income to minimize overall tax liability.

Liability Protection

If your business operates in a high-risk industry or has the potential for legal claims, incorporating can provide limited liability protection. By separating personal and business assets, you can protect your personal assets from business debts and legal obligations.

Long-Term Goals and Succession Planning

Incorporation can offer advantages for long-term business planning and succession. If you have plans to expand your business, raise capital, or pass it on to future generations, incorporating provides a more structured and transferable business entity.

Cost-Benefit Analysis

Consider the costs associated with incorporation, such as government fees, legal fees, and ongoing administrative expenses. Evaluate these costs against the potential tax savings and benefits to determine if the overall financial advantages outweigh the upfront and ongoing expenses.

It’s important to consult with a qualified tax professional or accountant who can assess your specific business situation and provide personalized advice on whether and when to incorporate.

Conclusion

Incorporating your business in Canada can offer significant tax benefits and provide legal protections for business owners. The limited liability protection and tax advantages, such as lower corporate tax rates, income splitting, and potential eligibility for the Lifetime Capital Gains Exemption, make incorporation an attractive option for many businesses.

However, it’s crucial to carefully consider the potential disadvantages, such as incorporation costs and ongoing administrative requirements. By weighing the pros and cons and seeking professional advice, you can make an informed decision about whether incorporating your business is the right choice for you.

Sebastien Prost, CPA

Written by Sebastien Prost, CPA

Seb Prost, a CPA with over 10 years of experience in taxation and accounting, offers a unique blend of insights from his time at the CRA and his experience in public practice. Originally from QC and now based in Nelson, BC, he specializes in guiding Canadian startups, SaaS companies and other online businesses for all of their accounting and taxation needs.

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