Taxes 101: Incorporation

October 4, 2023

Emily Mantle

Ah, incorporating. 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. Accountants will often assist in ensuring a flexible share structure is provided for in the original incorporating documents that will facilitate future tax planning. When you establish a corporation, you are establishing a separate legal entity. You continue to be an individual for tax purposes and your corporation is a separate legal entity. You will own shares of the corporation.

As you’re still an individual, you still have to continue filing an annual personal income tax return; however, your personal income tax return will no longer include the self-employment schedule relating to your unincorporated business activities.

Similarly, your new corporation will file a corporate income tax return annually. From a money flow perspective (show me the money!, right?), the corporation will collect business income from your customers/clients. Your corporation will pay for business expenses, and the corporation will pay corporate income taxes on its net income.

Of course, you still need funds to live on and will remove funds from the corporation for your personal use. Generally, any distributions from your corporation to you personally will either be taxed to you personally as 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 your business activities is to benefit from “tax deferral”. If you follow me on any social media platform, 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 how tax deferral works and see it in action.

We will start off by acknowledging that combined personal tax rates in Ontario range from 20% all the way to 53.53%. We are taxed progressively in Canada, meaning that every dollar that is earned is subjected to the marginal rate of tax for income in that particular bracket.

The top bracket for 2023 has recently been announced and is set at $235,675. This means for those earnings self-employed income more than $235,675 in 2023, every additional dollar of other income earned will be taxed at a combined rate of 53.53%. Yikes! That’s a hefty tax bill be written remitted to the Canada Revenue Agency, particularly if those additional dollars earned aren’t needed for lifestyle needs.

In contrast, active business income earned inside of a corporation up to $500,000 is currently taxed in Ontario at a flat rate of 12.2% and 26.5% thereafter.

If your corporation earns $300,000 of taxable income, the corporation will only pay $36,600 in corporate income taxes assuming the income is active business income eligible for the small business deduction. Remember the complexity though – this is the first level of income taxation.

You the individual will then have to pay personal income taxes on any distributions from your corporation for personal living needs (the second level of taxation). However, you get to choose how much money you withdraw from your corporation and ultimately expose to the higher personal tax rates annually.

The funds not withdrawn annually from your corporation will remain inside the corporation. This can help you to accumulate wealth or grow Your business quicker than you may otherwise have been able to.

Remember, those funds “left behind” have only been subjected to the first level of taxation – at lower corporate rates.

Finally, since some businesses can be volatile where some years are “up” and some are “down”, a corporation can provide you the flexibility to be able to manage your personal income from year-to-year.

In “up” years, you can benefit by leaving funds inside the corporation since you don’t need the funds personally and in “down” years, you will have funds left from years prior that you can distribute from your corporation to supplement your personal living needs.

 

Where Do You Go From Here?

As there are costs and complexities involved in implementing a corporate structure, a good starting point is with an accountant. An accountant can meet with you to run a hypothetical incorporation scenario that can illustrate whether you would benefit from incorporating based on your particular circumstances and needs.