Why you should incorporate

2022 is a completely new frontier for finance and business, we are living in unprecedented times! Never before have we seen this level of financial sophistication, today you can invest on your own, youtube the best budget strategies—it's a tidal wave of information and I am grateful for it.

As a business owner, the decision to incorporate is a big one!

"What does incorporating mean?"

First off, incorporating is the process of becoming a legal corporation. Corporations, from a legal standpoint, are recognized as a "real person" so they can get into contracts, own property, get loans etc...

There are typically 4 main reasons a business owner chooses to incorporate. The first is business related and the other 3 are more tax related.

1. Creditor Protection
2. Access to Low Tax Rates
3. Tax Deferral on Profits
4. Access to the lifetime capital gains exemption

Creditor Protection

From a legal position, a corporation is treated as a separate person. This offers owners (shareholders) protection from the corporation's creditors. Here's an example: let's say you have a business (non-incorporated) that sells skateboards and due to a manufacturing error, a customer got injured. That injured person could sue and, if successful, all of your personal assets could be exposed and used to satisfy the damage claims of said injured person.

No one wants that.

Now how would the situation above be treated for an incorporated business? If the same situation happened and you are an owner or shareholder of the corporation that made the skateboards, only the corporation's assets would be exposed/used in a successful lawsuit.

This is much better position to be in, not only is this a form liability protection but it creates an incentive. Business owners are encouraged to pursue business activities without putting their personal wealth at risk!

There are limits to the creditor protection offered by corporations. For example, a lender may ask a shareholder (business owner) to give a "personal guarantee" on a loan extended to their corporation (meaning they might have to use personal assets as well to secure a loan). In cases of proven fraudulent or illegal activity, creditors could bypass the stated protection and have access to personal wealth.

Low Corporate Tax Rates on Active Business Income.

Corporations typically have two tax rates applicable applicable to "active" income (for example, revenue made from the sale of products and not passive sources like rental income, interest or royalties). The first tax rate is known as the small business rate of approx. 12% in several provinces, this applies to a corporation's first $500,000 of active business income. The $500,000 threshold is called the small business limit or "SBL" for short.

Fun fact: only Saskatchewan has a higher limit of $600,000.

The second rate tax is approx. 27% offered in several provinces, this rate applies to active business income that's over the SBL (small business limit). The table below displays the tax rates for active business income below and above the SBL throughout the provinces as of Jan 1st, 2022.

These relatively low tax rates gives a significant incentive to incorporate. Lower taxes on business income means a lot more after-tax income. This income can be used to reinvest in the company or purchase financial assets like investments for example.

Tax-Deferral on Profits and Potential Retirement Savings

Tax-deferral means exactly that. It's the idea of paying taxes at a later date, this is particularly helpful if you are in a lower tax bracket. You still pay taxes on your income but at a lower income tax bracket, so you earn making higher income and withdraw said income paying less. An RRSP, for example, is popular tax-deferral strategy.

In the business world, those who conduct business as sole proprietors are taxed at their personal marginal tax rates on their active business income. Compared to when a corporation generates income, it is taxed at the corporate level first and then taxed again when distributed to shareholder(s) as a taxable dividend. (I.E. Taking the money out).

In practice this is done so the tax payable is equal to the amount of tax paid by a sole proprietor earning the same amount of business income. This is called tax-integration but perfect tax integration is rare to achieve.

There's an opportunity for the corporation's after-tax earnings to be kept at the corporate level, or in the business, and not paid out the shareholder as a taxable event, if the funds aren't needed by said shareholder. Business owners can achieve tax-deferral by keeping their after-tax earnings in the corporation. A lot of business owners often have their retirement nest egg held at the corporate level for this reason.

The table belows summaries the treatment of $100 of income at SBL level ($500,000), above SBL (over $500,000 or general rate) and as a sole proprietor as compared to a corporation. Assume the sole proprietor is generating the same amount of business income.

Based on this table, it's easy to see why someone would leave their savings or retirement funds inside of their corporation.

Access to Lifetime Capital Gains Exemption

The lifetime capital gain exemption is a big tax-benefit to shareholders who sell or are deemed to dispose of, for tax purposes, their "qualifying small business corporation shares (QSBC share for short).

Generally, a QSBC share is a share of a Canadian-controlled private corporation of which at least 90% of the value of its assets are principally used in active business carried mainly in Canada. There are a few other conditions but this is the general theme. The exemption in indexed annually (raised to match with inflation).

Another fun fact: Owners of a qualified farm or fishing property are eligible for an enhanced $1,000,000 lifetime capital gains exemption.

Considerations when incorporating a business

Anyone looking to incorporate should consult with their legal and tax advisors before setting up a corporation. The following tax, legal and business items are good food for thought:

• Will the business endure and be part of a succession plan?
• If there are business partners, will there be a shareholders' agreement?
• How will the owner-manager client be compensated? Dividends, salary, or both?
• Will all of the business assets, such as intellectual property, be transferred to the corporation and will it be done on a tax-deferred basis?
• How does corporate wealth accumulation affect estate planning?

Incorporating has several phenomenal benefits and should be thoroughly explored for any individual earning active business income.

Your neighbourhood advisor,

-Joel