What to do to avoid the deemed dividend trap.
Research tax-efficient structures to facilitate real estate investing.
Using the Income Tax Act to avoid tax.
Utilizing the butterlfy.
Navigating through the delicate nature of non-arms length transactions.
Sole Proprietorship vs Corporation – How to set up your business
Many people considering a venture into the foray of business ownership eventually need to make a decision as to how to operate: as a sole proprietor or as a corporation. Our office fields this question quite often, and below we review the salient points of each that must be considered before pulling the entrepreneurship trigger. Depending on an individuals’ situation, mindset and business prospects, either one can be the right decision. Following, however, is our debate on the question:
Sole Proprietorship is an inexpensive, simple way to commence business operations. The process to set up a sole proprietorship is as simple as requesting a name online with the applicable government body, and, once the name is approved, go to your financial institution with the approval document and request a bank account opened in that name.
Taxpayers in Canada report sole proprietorship activities on their personal income tax returns, and the net income generated from the business is taxed as personal income and subject to personal marginal tax rates, just like employment income.
However, taxpayers operating sole proprietorships have no ability to engage in tax planning or tax minimization, since all income is taxed at marginal rates. Such a limit therefore requires considering the pros and cons of incorporating.
Essentially, from a cash flow perspective, the differences between sole proprietorship and employment income are that a sole proprietor does not need to pay Employment Insurance premiums, and also gets to deduct all expenses incurred in the process of operating the business.
Individuals can also operate a business through a corporation, which in Canada is considered a separate entity for tax and legal purposes. The process to set up a corporation is not as simple as is establishing a sole proprietorship, although it can be done via online sources. Corporations are normally established with the assistance of lawyers or Notary Publics, and involve securing a name for the corporation, applying for a certificate of incorporation from the applicable provincial government body, and issuing shares in the corporation. Other relevant items to corporations are as follows.
- Tax planning
Because corporations are considered separate legal entities, all net income generated by the corporation is taxed at corporate tax rates, as opposed to being subject to the personal marginal rates. The corporate rates are lower than personal rates, providing for the ability to “defer” the taxation of income until it is withdrawn from the corporate account and deposited into the owners account as either salary or dividends.
The owner has the choice of extracting money from the corporate account as either salary or dividends. Salary being the method used to compensate the owner as an “employee”, since they are n entity themselves separate from the corporation, and dividends being the method used to provide the owner as shareholder the equity, or after tax capital, generated by the business.
The ability to tax plan in this context comes exists when money can remain in the corporate account, and therefore not be subject to higher personal tax rates.
For example, as a sole proprietor generating $50,000 in net income and in a personal tax bracket of 20%, the income tax payable on this amount would be:
Income tax ($50,000 * 20%) $10,000.00
CPP contributions 2,301.75
Employer CPP match 2,301.75
If the income as generated in a corporation, and the owner decided to withdraw a salary of $30,000, the tax effects are as follows:
$20,000 net income in corporation
Taxed at 13.5% (combined federal and BC provincial rate) $2,700.00
Income tax on $30,000@ 20% 6,000.00
CPP contributions 1,311.75
Employer CPP match 1,311.75 8,623.50
The tax amounts used in this example do not take into consideration any personal and other tax credits that may be available to the owner on his/her personal tax return.
Under both scenarios, the amount of money remaining under the control of the owner is as follows
Less: tax and CPP (14,603.50)
Less: tax and CPP (8,623.50) 21,376.50
Net income 20,000.00
Less: corporate tax (2,700.00) 17,300.00
As can be seen, there is more money under the control of the owner by using the corporation as opposed to using the sole proprietorship model. Although the difference may seem small ($3,280.00), the tax deferral benefits increase as more net income is generated in the corporation.
Owners therefore need to determine at what income point a corporation makes sense. If the owners knows what income s/he needs in order to live, and if s/he prefers to keep money in the corporation to finance expansion as opposed to taking the extra money out and then paying additional personal tax on that income, then a the business should be operated through a corporation. The final income number that determines this course of action is different from individual to individual.
If the owner withdrew all of the $50,000 from the corporation, the income tax effect would be the same as if s/he made the income as a sole proprietor. The tax benefit to a corporation, therefore, exists as long as the owner can keep some money in the corporation and prevent the income from being taxed personally.
This may or may not be an option for some owners, who may need all the money that the corporation generates in order to live. So on criteria that’s used to determine whether or not to operate as a corporation is to assess whether or not future net income levels will rise to the point that money will not be used personally but rather will remain in the corporate account and be used to fund expansion. If the owner intends to use money to advertise, finance the purchase to purchase capital assets, or take on debt within the company, then the viability of operating through a corporation becomes more tangible than operating as a sole proprietor.
- Income splitting
Operating your business though a corporation also provides income splitting opportunities with spouses and /or other family members. For example, family members can be issued salaries in amounts commensurate to the type and quantity of work that they do. What is more common, however, is to issue shares in the corporation to family members so that they can receive dividends from the corporation.
For example, assume that a business owner operates his business through a corporation with 2 shareholders – himself and his wife. Also assume that the business generates $100,000 in net income and all is taken out via dividends. The tax differences are as follows:
$100,000 taxed as income in the
corporation ($100,000 * 13.5%) $13,500.00
Each of husband and wife
Receive dividends of
(($100,000 – 13,500))/2 =
$43,250 – taxed at 10% after
Dividend Tax Credit:
Husband ($43,250 *10%) 4,325.00
Wife ($43,250 * 10%) 4,325.00
Total tax paid $22,150.00
If running as a sole proprietorship, the owner has no ability to split income, and therefore the total amount of $100,000 is included in his income. At this income level, the husband’s tax rate on this income is 25%
$100,000 * 25% $25,000.00
Again, the higher the numbers go the greater the benefits will be to splitting income.
- Capital Gains Exemption,
In Canada, the gain on the sale of shares in certain corporations established in Canada are exempt for tax. The amount of gain sheltered from tax is capped at $848,252 meaning that a shareholder of certain shares in a certain corporation does not have to pay tax on up to $848,252 of gain on his/her shares. This can translate into a tax savings of up to approximately $115,000. Such a huge potential tax saving is not available if operating as a sole proprietor.
Most business operators will set up corporations long before their businesses are at the point where the value of the business will get to $848,252. However, it’s relevant to determine at which income level it becomes a good idea to incorporate.
The answer to this question will vary among individuals, depending on the amount of money they need to take out of a corporate account their growth prospects.
Aside from determining the appropriate amount of income beyond which it may become necessary to operate your business through a corporation, the other reasons above may make it worthwhile to set up a corporation initially, regardless o the income generated. Some professional associations, such as Chiropractic associations, require practitioners to operate their clinics through corporations.
Also necessary to consider is the cost of setting up a corporation with the assistance of a lawyer or a notary public, unless you want to establish a corporation yourself online. However, the initial cost is normally not a hindering point once the answers to the above issues have been clarified and have pointed to a corporation as the best method of business operation.
So a discussion of all the relevant factors is necessary to determine if a sole proprietorship of corporation is the right method of operation for you. Before making the final decision, speak to us to make sure that you’re doing the right thing for your specific situation.
Nicholas Kilpatrick is a partner at the accounting firm of Burgess Kilpatrick in Vancouver, B.C.. He concentrates his practice on assisting business owners with accounting services, tax and estate planning and overall business development.