Integration of Canadian Personal & Corporate Taxes
Kalfa Law practices at the intersection of tax and corporate law, and often advises businesspeople on whether or not incorporating their business may be beneficial from a tax perspective. This is a complicated decision—operating through a company provides many tax benefits, including (now closely circumscribed) opportunities to split income and easier access to the Capital Gains Exemption, along with disadvantages, particularly increased compliance costs, complexity, and double taxation risks.
However, the most obvious issue involved in the decision to incorporate, and the question we field most often, relates to the reduced corporate tax rate. It is certainly true that corporations, particularly closely held companies, have a meaningfully lower tax rate than individuals in higher income tax brackets. However, looking at the corporate rate in isolation does not provide the complete picture, as corporate profits need to be passed on to the individual to be spent. The Canadian tax system aims to tax individuals similarly regardless of whether they earn income from a business through a company or personally using a process known as “integration”.
We will illustrate this using a simple example of a corporation with a single shareholder, single officer, single director corporation resident in Ontario, operated by a man named Jimmy.
In this example, the Corporation has $100,000 of retained earnings at the end of the year, all of which were its profits from operating in Ontario in 2020. The Corporation is a Canadian Controlled Private Corporation, and all of its income is income from an active business that is eligible for the small business deduction. Jimmy has no other sources of income, and also resides in Ontario. At the end of the year, the Corporation’s income tax liability would be its profit multiplied by Ontario’s tax rate for small business income (12.2%), resulting in tax payable of $12,200. If Jimmy had earned this income through a sole proprietorship, he would have tax payable in the amount of $28,306 (all personal taxes payable are subject to many other factors, but this is a helpful starting point). We will also assume that Jimmy has personal expenditures of $71,694, which is his after-tax income from $100,000 if he earned all of his income through a proprietorship.
Typically, Canadian small business owners compensate themselves by paying themselves a salary (which includes bonuses), or by declaring dividends (or a mix of the two).
Salaries and bonuses are taxed as employment income in the hands of the officer and are generally deductible to the corporation—which effectively shifts the Corporation’s income tax liability to Jimmy. The Corporation would claim a $100,000 deduction for the salary, resulting in profits and income of $0, and pay $0 of income tax. Jimmy would receive income from employment in the amount of $100,000 and pay income tax of roughly $28,306
In contrast to payment via salary, corporations cannot claim deductions for dividends issued to shareholders. The Canadian tax system “integrates” the total tax payable between Jimmy and the Corporation through a dividend-gross-up-and-credit system. In this case, Jimmy’s corporation will want to hold back some funds to pay its own expected corporate income taxes but wants to pay the rest to Jimmy in the form of a dividend. The Corporation declares a dividend in the amount of $87,800, holding back $12,200 for its own taxes.
The first step in the dividend integration system is a dividend “gross-up”. When paid to an individual, the individual includes in income more than the actual value of the dividend—it is increased by 15%. The amount that is included in income is increased so that an approximation of the Corporation’s full profits are taxed at Jimmy’s marginal rates, notwithstanding that the Corporation has independent income tax liabilities. Multiplying the $87,800 dividend by 1.15 provides Jimmy with taxable income of $100,970, and so he would pay income tax in the amount of $28,721.
However, without any further adjustments, Jimmy would be paying (more or less) the same amount of tax as he would if he were compensated by salary, but the Corporation would also be paying income tax. Fortunately, the dividend the Corporation paid also entitled Jimmy to an offsetting credit that accounts for income tax paid by the company, referred to as the dividend tax credit, which reduces his tax payable by an amount equal to the credit. The end result is that Jimmy has tax payable in the amount of $17,151. Combined with the company’s tax, they collectively have tax payable in the amount of $29,351.
So, Jimmy earning money through the Corporation and paying himself a salary provides no tax savings relative to earning it personally (it would also alter some benefits and credits, but this effect is fairly marginal). Similarly, earning money through the Corporation and paying himself dividends does not meaningfully impact taxes payable (it actually increases it by about $1,000).
These simple examples illustrate the point that lower statutory corporate tax rates, in and of themselves, do not provide notable tax savings when the business owner intends to spend all of their profits in a given year. Similar rules apply to public and non-Canadian-Controlled corporations (which pay a higher tax rate but dividends from which are taxed at a lower rate through a more generous dividend tax credit), and to the investment income of companies like Jimmy’s (which is taxed at the highest marginal rate in the corporation, with some of these taxes refunded when dividends are paid).
So, when is the corporate tax rate useful? Primarily when Jimmy does not need to spend all of his money in any given year, leaving him some to save. This can take the form of financial investments (e.g., mutual funds) or capital purchases for the business (e.g., vehicles, computing equipment), which are depreciated over several years rather than claimed as an expense immediately.
For example, if Jimmy had earned $150,000 in his personal capacity, he would pay tax in the amount of $50,004. Less his personal expenditures ($71,694), he would have $28,302 left over to invest. If he were incorporated, paid himself a salary of $100,000 which he used to cover his personal expenditures, and kept his retained earnings in the Corporation, the Corporation would pay tax of $6,100 and have $43,900 left over to invest. This is complicated by elevated tax rates for investment income of Canadian Controlled Private Corporations (in that they pay higher tax on passive income than individuals in lower brackets), but the point stands—the lower tax rate available to the Corporation provides Jimmy with significantly more money to invest.
Similarly, it can be used for businesses that fluctuate from year-to-year to reduce taxes payable by spreading income over several years. For example, if Jimmy had not incorporated and had earned $150,000 in one year and $50,000 in the next, he would pay income tax totalling $61,963 ($50,004 in the first year and $11,959 in the next). If he earned those same amounts through the Corporation, he could reduce his taxes by paying himself a salary of $100,000 in the first year (paying $28,306 personally plus $6,100 for the Corporation), and paying himself a salary of $50,000 in the second year along with a $50,000 dividend (for a total of $24,040 in the second year), resulting in total taxes paid of $58,446 for both years.
So, this is to say: while incorporating one’s business allows a reduced tax rate, this does not translate into significant tax savings if one intends to spend all of their income. However, with careful planning, incorporation can provide substantial benefits to individuals with excess income at the end of the year, particularly individuals who have already exhausted their personal tax-advantaged vehicles (e.g. RRSPs, TFSAs). Otherwise, incorporation primarily offers non-tax benefits (in particular, limited liability), can be used to help plan for tax benefits after their business grows, and in some cases can be used to “split” income between family members to access tax credits and lower marginal rates.
This is also a complicated decision, and is quite fact-specific. Among other considerations, one of the benefits of paying yourself a salary is that this will help you accumulate room in your RRSP, but paying dividends helps you to avoid income tax withholding on payments. If you want to pay yourself by dividends, but still wish to receive a steady low of funds from your company, you can borrow money from the company and declare dividends periodically to credit your shareholder loan account.
One of the most important considerations in choosing whether or not to incorporated is one’s exposure to creditors, and particularly “involuntary creditors”, or creditors who do not choose to be in a debtor-creditor relationship with you. Voluntary creditors, such as banks and lenders, will often require security from a director before providing credit, and so the corporation’s limited-liability function is less valuable. However, businesses that have a high risk of injuring others or getting into contract disputes should strongly consider incorporation.
For example, independent contractors operating from home and providing services to a single client will receive relatively little from liability projections offered by incorporating, while businesses that invite the public to their premises should strongly consider incorporating to limit their exposure to lawsuits.
In addition to the fees and expenses required to incorporate a business, operating a business through a company involves additional maintenance of corporate records, which typically means paying fees to lawyers. Corporations’ T2 income tax returns are also more complicated, which increases the fees for professional expenses.
However, there are also some hidden costs under tax rules. For example, some “taxpayer relief” provisions are not available to corporations, particularly rules that allow them to amend their income tax returns beyond the normal reassessment period.
-James Alvarez, Tax Counsel
© Kalfa Law 2020
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.