For many individuals, a significant factor in deciding to incorporate is the potential advantage of providing the shareholders with limited liability where the business is carried on in a corporation.

However, there are also certain tax advantages and disadvantages that may arise as a result of incorporating a business.

Theoretically, integration should cause the total tax paid on income earned in a corporation and then distributed to its shareholders to be equal to the total tax paid by an individual who earned the same income directly and not through a corporation.

However, imperfections in the integration system arise primarily as a result of different corporate tax rates applicable on various types and levels of income.

Accordingly, depending on the circumstances and the manner in which a shareholder/manager is remunerated, that individual could be either better or worse off by incorporating.

Advantages of Incorporation

Tax savings: The 2003 corporate income tax rate on the first $225,000 of active business income eligible for the Small Business Deduction (SBD) in Ontario is approximately 21 per cent. Any income in excess of $225,000 will be taxed at a rate of approximately 37 per cent.

Because of the Ontario small business deduction surtax or "SBD clawback", the corporate tax rate for active business income in Ontario can be as high as approximately 44 per cent. This Ontario surtax will apply to taxable income in the range of $200,000 to $500,000.

The top combined federal and Ontario personal income tax rate in 2003, which applies on taxable income of approximately $104,468 and over, is approximately 40 per cent.

Tax deferral: Tax can be deferred by retaining up to $225,000 of active business income in the corporation so that it will be taxed at the low small business rate.

The difference between the personal marginal income tax rate and the small business rate results in tax deferral. This will be of interest to individuals whose business income in their corporation is greater than their own personal cash requirements.

Another tax deferral technique may be available through the accrual of a bonus at the corporation's year-end.

Income splitting: Income splitting may be available in carefully planned situations by having family members as employees or shareholders and paying these individuals reasonable salaries or dividends, as appropriate.

Estate planning: Estate planning advantages may be possible by issuing shares to children or other family members thereby transferring all or a portion of the future growth in the corporation to the children or other family members.

Capital gains exemption: Establishing a corporation may enhance the ability to claim the $500,000 capital gains exemption on a sale of the shares of the corporation.

Non-deductible expenses: Certain non-deductible expenses paid through the corporation can result in tax savings if the corporation's tax rate is lower than that of the shareholder.

Other Advantages
- possible limited liability for shareholders
- separation of business and personal activities
- stabilization of income of the individual through salary payments
- flexibility of the timing of the receipt of income subject to personal tax

Disadvantages of Incorporation

Expenses: The expense of forming a corporation and of complying with the annual requirements for meetings and filing of notices must be weighed against the advantages of incorporation.

Federal income tax returns must be filed annually. In addition, provincial tax returns are also required in certain jurisdictions such as Ontario and Quebec and these provinces also levy a capital tax on corporations.

Loss utilization: A corporation may incur start-up losses that may not be deducted until income is earned in future years.

For the sole proprietor who carries on business personally, start-up business losses can be used to offset other personal income.

Books and records: Separate books and records for the corporation must be maintained.

Personal funds will need to be separated from the corporation's funds and withdrawals, such as loans and advances to shareholders from the corporation for personal use, will be subject to strict provisions in the Income Tax Act and could be subject to tax or imputed taxable interest benefits.

Investment Income

Investment income does not qualify for the small business deduction. Such income will be taxed at a rate of approximately 48% in Ontario. However, this may still provide tax deferral benefits if the individual shareholder otherwise pays tax at the top marginal rate of 49%.

General

Generally, the tax savings, if any, or deferral opportunities associated with incorporation, will outweigh the disadvantages of incorporating. However, a taxpayer must review carefully the advantages and disadvantages before proceeding.

It is relatively simple to incorporate a business, however, it is more difficult to reverse that decision and take the business out of the corporation.

The above provides general information only. It should not be regarded or relied upon as accounting or taxation advice or opinions. Logan Katz LLP Chartered Accountants would be pleased to provide more information or specific advice on matters of interest to you.
 

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