To Have and to Hold (Part I of 2): Is Incorporating Right for you?

June 2024

Stephanie Pantaleo, CPA, MTax, CIM^®
Vice President, Family Office Services

 

Are you contemplating the incorporation of your business or professional practice? Do you have a large investment portfolio and are curious of the tax implications for utilizing a corporate structure to house your portfolio?

Many Canadians choose to incorporate their business affairs or investment portfolios/properties, known as an investment holding company, or a “HoldCo.”  While there are many non-tax-related reasons for incorporating, a primary consideration for choosing to incorporate may be to take advantage of the corporate tax rate regime.

In contemplation of whether incorporating is the right option for you, it is important to first assess whether such a structure will accommodate (or complicate) your personal cash needs, and whether this outweighs the potential tax benefits you may receive. Because this decision plays into your everyday life, the incorporation of your business practice or investment portfolio should also be viewed as a long-term commitment, rather than a short-term solution.

The Principle of Integration

Generally, the Canadian tax system is structured on a principle referred to as integration. The underlying concept is that income earned by a Canadian corporation, then paid to an individual as a dividend, should equate to the same amount of tax had the income been earned directly by the individual.

For example, if an individual earns $100 of business income in a corporation with a 12.2% tax rate, the after-tax corporate earnings available for distribution as a dividend amounts to just under $88. An individual subject to tax at the top marginal rate residing in Ontario will pay $42 of tax on the $88 dividend, leaving the individual with approximately $46 in after-tax personal funds. Had the individual earned the $100 of business income directly, they would pay personal taxes of 53.5% on the $100, also leaving them with approximately $46 in after-tax personal funds (1).

Incorporation of Business Income

 If integration is intended to ensure that an individual would be overall indifferent earning business income directly versus indirectly via a corporation, is there a tax benefit for incorporating?

The answer: it depends.

To illustrate, a corporation resident of Ontario earning business income eligible for the small business deduction is subject to a rate of 11.2% – i.e., the small business rate. Business income earned by a corporation resident of Ontario not subject to the small business rate, pays tax at 26.5% – i.e., the general rate. A top income earner residing in Ontario is subject to the top marginal rate of 53.5%. Contrasting this personal tax rate to the corporate business rates noted above, we are looking at a difference of 27.0% and 42.3% of tax dollars. Whether a corporation is paying taxes on business income at the small business rate or the general rate, there is evidently more after-tax dollars available in the corporation versus an individual earning such business income directly.

However, we cannot stop there. A tax “benefit” may arise depending on what the corporation does with those after-tax dollars.

If the after-tax earnings of a corporation earning business income are immediately paid out to the individual shareholder by way of a dividend, there would be no tax benefit of incorporating such income. The individual could have earned the income personally and paid their personal tax instead, as illustrated in the previous section. In fact, the individual would likely be worse off having incorporated from an overall cashflow perspective once corporate expenses (for example, legal and accounting fees) are considered.

If such after-tax dollars are maintained in the corporation instead, and not paid to the individual, then the individual will not incur the personal tax charge, demonstrating the personal tax deferral that is available with incorporation. Although this publication details the incorporation of business income, after-tax dollars maintained in the corporation may be reinvested giving investment income. The corporate tax rules surrounding investment income are more complex, and may limit the availability of the small business rate depending on the amount of investment income earned in the corporation.

In any case, personal taxes will be paid, but only once the funds are extracted from the corporation. Put simply, the longer the corporation “holds” the after-tax dollars without payment to the individual, the more the individual benefits from this personal deferral, thereby maximizing the tax benefit that incorporation offers.

Planning and Execution

Now, what kind of advice would it be to say that an individual should lock up their earnings in a corporate entity and not extract a cent? We all need funds to live!

It takes good planning to determine whether the incorporation route is one to pursue. Quantifying your expected earnings versus your everyday expenses – in other words, preparing a budget – is a reasonable starting point to determine the annual savings you would maintain in the corporation net of corporate expenses.

Even then, there are personal savings vehicles which are also available to consider: the Tax-Free Savings Account (TFSA) and Registered Retirement Savings Plan (RRSP), and now, the First Home Savings Account (FHSA), which may also act as suitable vehicles for personal savings. Further, it is critical to consider the intended use of those savings and the expected time horizon for the use of such funds. This will help you project whether it is worthwhile committing to a corporate structure or not, an exercise that can be undertaken with a financial plan.

On the surface, it is tempting to access to the corporate tax regime versus paying the tax at the personal rates. However, the decision to incorporate may result in a personal tax deferral, not exactly a tax savings. The longer the funds are held in the corporation, the more an individual will benefit from this deferral. Personal taxes will be paid, it is just a matter of when. Lastly, remember that there are also non-tax reasons for incorporating your business, and tax is just one of many considerations for doing so.

Now that we have covered the incorporation of business income, does the same narrative hold true for incorporating investment income? Well, that’s a love story for another time.

 

The incorporation of investment income will be covered in a future publication of Pembroke’s Perspectives.

 

 

 

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