Incorporation Basics – What is a Corporation and Incorporation Advantages Part 1 – Lower Effective Tax Rate

 

Many professionals are busy wondering how recent proposed federal government changes by Bill Morneau will affect the value of incorporation.  For those with corporate structures, many will have already read opinion pieces that give an idea of what will likely change if proposed measures are finalized in October 2018. I found the following article to be a fairly good overview, but many articles presume a basic understanding of corporations and their benefits. I read the very detailed 63 page document produced by the federal government quite closely, but it has some challenging parts to understand for many non-accounting professionals.

I began writing about all the proposed changes in a very technical post, but then realized it will likely be of greater value to readers to start with current incorporation basics and comment on how proposed changes will affect things moving forward. . My general advice during this uncertain time to new non-incorporated professionals is don’t waste money to incorporate until news in October.  If you already have a corporate structure, no rash decisions such as dissolving your corporation need to be made at the moment until the final decision comes through. Many will still find benefit to incorporation even under the proposed changes, but the decision will certainly require more detailed analysis than before.

I hope these posts can help provide a refreshing independent look at evaluating the value of their corporation moving forward. It is a big topic and therefore will be split into a series of posts. Just like all my posts, I prefer to start with the basics and ease into the complexity. This post series comes with a huge disclaimer – I am not an accountant and don’t have any corporate expertise. I haven’t had the opportunity to review any posts formally with my accountant and everything is based only on what I have read. Please contact your accounting professional regarding any formal decisions you need to make.

What is a Corporation

A corporation is a separate legal entity. It can earn income, enter into contracts, purchase real estate, investments and other property, and pay taxes. There are two main types of companies in Canada, each with different income tax and accounting rules.

A public Canadian company generally has its shares listed on a stock exchange and anyone can invest in it. Well known examples would be RBC,  Bell or Rogers. These companies have a general corporate tax rate that is the combination of the federal rate of 15% and the provincial rate which ranges from 11% in BC to 16% in the Maritimes. For simplicity we will call the public company combined corporate tax rate 27% on average.

A private Canadian small business company (also known as a Canadian-Controlled Private Corporation or CCPC) is not publicly traded, but owned by a private group of shareholders. This may be one person or many depending on how the private company is structured when it is made. A CCPC has a small business federal tax rate of 10.5% and the provincial rate range of 0% in Manitoba to 8% in Quebec, but most are in the 2-4% range. We will use a combined small business rate of 13.5% on average – notice this is HALF the general combined corporate tax rate.

A professional corporation is a type of private CCPC governed by provincial legislation and the rules and regulations of each profession’s governing body. Many health professional corporations are regulated by a provincial Health Professions Act that they need to comply with. These rules often include restrictions on who can own shares in the company, what the company can own and do, and even on what the company can be named.

Not every profession in a province is permitted to practice through a corporation. Business professionals that can incorporate include (there are likely more than listed):

Accountants

Architects

Engineers

Lawyers

Mortgage Brokers

Realtors

Doctors, Physiotherapists, Dentists, etc.

Disadvantages of Incorporation

The primary disadvantages of using a professional corporation are straightforward:

a) Initial Incorporation Costs – these can range in the $2000-$3500 range per corporate structure. Some individuals have just a professional corporation, while some also have a holding company and/or a family trust. Each extra entity may have advantages we will explore later, but they will each have their separate initial cost which means it may reach the $10,000 range for all 3 entities.

b) Annual Accounting and Legal Costs – this may range between $1000-$3000 / legal entity/year. So for all 3 entities, this can get up to almost $10,000/year of recurring cost.

c) Headache factor – There is no question having a corporation adds complexity that will take up more of your time than if you weren’t, even with accounting and legal professionals involved. This pertains to setting up the corporate entities as well as ongoing maintenance.

My general opinion is that you need to see a minimum hurdle of $10,000/year of value before entertaining the cost of incorporation. So where does the value come from?

Advantages of Incorporation – Lower Corporate Income Taxes

a) Canadian Progressive Income Tax system

Understanding the Canadian personal tax system is more complicated than the corporate. The personal is a progressive tax system while the corporate is closer to a flat tax system. Most tax tables are confusing, but I like these ones courtesy of Tax Tips which I will ask you to open separately for this part of the discussion (couldn’t find a way to embed in the post – tech savvy people let me know how!)

2017 Federal Personal Tax Table

2017 Provincial Personal Tax Table – I will use BC as my reference, but you can individualize with your own tax table here. Note that the Tax Tips provincial tables do a great job of combining the federal/provincial effective rate underneath the quoted provincial rate. Please only focus on the “Other Income” section which refers to Employment Income/Salary for this part of the discussion (I will cover the other stuff later)

Many people think that if they earn a certain income such as $100,000, they pay the exact tax rate quoted in the BC combined table of 38.29% on the whole $100K which would equal $38,290 of income tax. This is how a flat tax system would work, but not a progressive one like Canada. As you can see from the table, you have a tax rate that applies to each range of income you earn.

The first ~$39,000 pays ~20% tax

The next ~$7000 (from $39-46K) pays 22.7% tax

The next ~ $22K (from $46-78K) pays 28.2% tax

And this continues on until earning over $202,800, when every dollar over that amount is taxed at 47.7%.

The $100,000 of gross income pays varying rates all the way up to $100K and actually comes to an average tax rate of 23.65% through the progressive system, not 38.29%.

There are many excellent online Canadian progressive tax calculators such as these:

 EY

Simple Tax  – note this deducts CPP/EI contributions as well

Of note, these tax bracket ranges are always changing year over year both in dollar ranges and effective tax rate. These changes are due to provincial or federal budget planning which adjust yearly. For example, these are some of the changes to BC’s highest marginal tax bracket over the years I have worked:

2009 – over $127K = 43.7% tax

2013 – over $135K = 43.7% tax

2017 – over $202,800 = 47.7% tax

High income earning professionals will see their average tax rate skew higher for each incremental dollar of income they earn over the highest personal tax bracket. For example (use the EY calculator for this example):

An Ontario professional who earns $250K salary will pay $97,190 in tax or an effective rate of 38.88%.

An Ontario professional who earns $500K salary will pay $231,014 in tax or an effective rate of 46.2%. Note the tax is 2.38x more than the first professional even though the earned salary was only 2x more.

A key take-away from the Canadian personal tax progressive system is that the more you earn at or above the higher tax bracket ranges, the higher your effective tax rate becomes. The higher this tax rate goes, the more potential benefit of tax deferral (not tax savings) by paying under the corporate small business tax system.

b) CCPC Small Business Income Tax System

I introduced the concept of the different small business corporate tax above, which has a flat tax average of 13.5% on active business income up to $500,000/year in most provinces. This $500,000 amount is AFTER business expense deductions (licenses, office lease, overhead, staff etc) and AFTER salary given to the professional. Any active business income above the $500,000 is taxed at the general corporate tax amount (same as public businesses as noted above) with an average of 27% corporate tax.

For clarity, a BC incorporated professional who had a gross business income of $750,000 less expenses of $100,000 and individual salary of $150,000 would have a leftover $500,000 of active business income all taxed at the 13.5% small business rate.

If the next year that professional were lucky enough to earn a gross business income of $900,000 with the same $100,000 expenses and $150,000 individual salary, then the active business income is $650,000. The first $500K is taxed at the small business rate of 13.5% and the extra $150,000 is taxed at the general corporate rate of 27%. The general corporate tax still looks much better 50% personal tax though right?

You may be tempted to ask why bother paying any income from the corporation when you can leave everything inside and pay only 13.5% on yearly income (up to $500K). The problem is that only the corporation can use that money now. As soon as you need money to spend for daily life, the corporation must pay that income out into a shareholder’s hands and be taxed personally. If you “save” taxes one year by keeping $200,000 after corporate tax behind but take that same $200,000 out next year for a house on top of your normal amount needed to live, you will still pay the top marginal tax bracket and deferring for one year has likely been of no advantage.

Final Thoughts

Everything discussed so far will be exactly the same for small businesses under the proposed changes as they are now including:

a) Incorporation rules and definitions

b) Professionals eligible for incorporation

c) Incorporation disadvantages

d) Personal and corporate income tax treatment

A major issue with tax treatment is that although lower corporate taxes remain unchanged, they mainly work to a professional’s advantage when combined with:

  1.  Income beyond what is needed for personal use (tax deferral for investment)
  2.  Additional individuals to distribute income to ( income splitting)
  3. More tax efficient and flexible options to distribute income personally (salary vs dividend income)
  4. Taking Income at Lower Tax Brackets In The Future (income smoothing)

This sets the stage for Part 2 and 3 where I will discuss current and proposed corporate tax changes which primarily affects tax deferred investment and income splitting.

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