Should you incorporate your small business? Let’s take a look at what incorporating means and when you may want to consider it.
Incorporation
Typically a lawyer sets up the corporation and accountants often assist to ensure a flexible share structure is provided to facilitate tax planning. When you establish a corporation, you’re establishing a separate legal entity.
As an individual, you remain a separate entity for tax purposes, while your corporation becomes its own legal entity, and you own shares of the corporation.
In addition, you must still file an annual personal income tax return; however, it will no longer include the self-employment schedule related to your business activities.
Your new corporation will file an annual corporate income tax return. From a money flow perspective, the corporation collects business income from your customers/clients and pays for business expenses. Additionally, the corporation will also pay corporate income taxes on its net income.
You will draw funds from the corporation for personal use. Generally, these draws (known as ‘distributions’) will be taxed to you personally as either a salary or dividends, and you will pay personal income taxes on those amounts.
Sounds Complex – Why Bother?
One of the main advantages of incorporating a business is to benefit from “tax deferral.” If you follow me on social media, you will know that my 4-Ds of tax planning include “deducting,” “deferring,” “dividing,” and “diverting.”
Outside of a deduction, deferral of tax is one of the next best things. Let’s get a sense of this particular benefit and see it in action.
Tax Deferring
Combined personal tax rates in Ontario range from 20% all the way to 53.53%. We’re taxed progressively in Canada, meaning that every dollar earned is subject to the marginal rate of tax for income in that particular bracket. Check the CRA website for yearly updated rates.
The CRA set the the top bracket for 2023 at $235,675. If your self-employed income exceeds $235,675, the government taxes every additional dollar of other income at a combined rate of 53.53% That’s a hefty tax bill! Especially if you don’t need those additional dollars for personal use.
In Ontario, corporations pay a flat tax rate of 12.2% on income up to $500,000 and 26.5% on income above that.
If your corporation earns $300,000 of taxable income, the corporation will only pay $36,600 in tax assuming the income is active business income eligible for the small business deduction. This is the first level of income taxation.
Next, you have to pay personal income tax on distributions from your corporation for personal living needs. This is the second level of income taxation. You choose how much money to withdraw from your corporation and ultimately, whether you’re subject to the higher personal tax rates.
Funds not withdrawn can help you accumulate wealth or grow your business quicker.
Remember, only corporate tax rates apply to the funds you leave behind.
Flexibility with Deferring
Some businesses can be volatile with “up” and “down” years. A corporation can provide you the flexibility to manage your personal income from year-to-year.
In “up” years, leave funds in the corporation if you don’t need them and in “down” years, draw more.
S0, should you incorporate?
There are costs and complexities involved in implementing a corporate structure. A good starting point is to speak with an accountant. An accountant can evaluate a hypothetical incorporation scenario to determine if incorporating benefits you based on your circumstances. Reach out to us at Compass CPA to explore if incorporating your business might be a better choice.
