You have been thinking about incorporating for quite some time. You have researched and reviewed the pros and cons and, just when you were ready to take the plunge, the government makes sweeping tax changes affecting corporations. The changes to the taxation of private companies introduced in 2018 have created additional layers of complexity and, at first glance, appear to dissuade incorporation, leaving you with more confusion than clarity. The question on your mind now is: In light of these new rules, does incorporation still make sense?
Interestingly enough, the principal reason for considering incorporation has nothing to do with taxes at all. Limited liability is and still remains the single most compelling reason to incorporate.
Limited liability means that the shareholders of a corporation are only liable to the extent of what they have invested in the corporation. Shareholders’ personal assets are protected from the debts of the corporation. As the corporation is a separate legal entity, it owns its own assets, incurs its own liabilities, has its own rights, requires its own tax filings, etc. Limited liability offers protection to shareholders.
The recent tax changes do not impact this limited liability protection. As such, if limited liability is an important consideration for you, perhaps given the legal risks prone to your business or the sensitivities of your personal situation, the recent changes should not dissuade you from considering incorporation.
Corporate Tax Rates
Another key reason for incorporating is to minimize taxes by taking advantage of the significant difference between corporate and personal tax rates. The 2019 combined corporate tax rate on the first $500,000 of active business income earned by a Canadian Controlled Private Corporations in Ontario is 12.5% (26.5% on income above $500,000). Comparing this to the combined top marginal tax rate for individuals in Ontario of 53.53%, the advantage is clear. Income earned in a corporation is taxed at lower rates than the same income earned personally.
This advantage was not affected by the new rules. Recent tax changes did not adversely affect the low tax rates on active small business income (the ‘small business rate’). In fact, further reductions to the combined corporate tax rate, from 15% in 2017 to 13.5% in 2018, and 12.5% in 2019, further amplified this advantage. As such, low corporate tax rates still remain a good reason to incorporate.
The point that is commonly misunderstood is that the low corporate tax rate is only an advantage if earnings are left in the corporation. The advantage is actually not a reduction of tax, but rather, a deferral of tax. This is because, in an integrated tax system like ours, the ultimate tax on the same income in the hands of the individual is designed to be the same whether it flows directly to the individual or indirectly via a corporation. When income flows to an individual via a corporation, the income is taxed at two levels – first at the corporate level and then at the personal level. Therefore, in order to benefit from low corporate tax rates, earnings must be kept in the corporation. Keeping earnings in the corporation defers the additional personal income tax you would otherwise have to pay. This personal income tax is deferred until the funds are withdrawn from the corporation. When these funds are withdrawn in lower income tax bracket years (for example, in retirement), tax deferral can also result in tax reduction.
This advantage was not affected by the new rules in 2018. As such, tax deferral by keeping earnings in a corporation still remains a good reason to incorporate.
Another advantage to incorporation centers around the use of funds left in a corporation. Tax deferral by keeping money in a corporation affords the corporation with more money now with which to grow for the future (than if otherwise withdrawn personally). Earnings left in the corporation can be used in a variety of ways. Excess funds can be reinvested in the business – in operations, in personnel, in capital, or for growth and expansion. Excess funds can also be invested to earn passive income (interest, dividends, rent, royalties). Investment income earned in a corporation is taxed at an upfront high corporate tax rate of 50.2%, but a refundable dividend tax on hand (‘RDTOH’) mechanism allows recovery of some of this high prepayment of tax upon payment of dividends to shareholders (recovery at a rate of $1 for every $2.6 of dividends paid).
This advantage was adversely affected by the new rules, which seek to dissuade the earning of investment income in a corporation. While the RDTOH mechanism remains intact, the new rules reduce the amount of income eligible for the small business rate in cases where passive income in excess of $50,000 is earned by a corporation. These rules reduce the $500,000 of income eligible for the small business rate by $5 for every $1 of passive income earned in the prior taxation year. Therefore, once passive income reaches $150,000 in a year, the 12.5 % small business rate is no longer available to the corporation in the following year. It is again important to note that the rate on the active business income would then revert to 26.5%, still significantly lower than the top marginal personal tax rate of 53.53%.
As such, while the new rules impose punitive measures based on the passive income earned in a corporation, there still remains an advantage, albeit reduced, to investing excess funds within a corporation.
Another advantage of incorporation is income splitting with lower income family members. In the past, you could set up your corporation with different share classes and pay dividends to family members at lower income brackets. Because dividends had no reasonableness test and given our graduated tax system (higher income taxed at higher rates), you could distribute income to low/no income family members and realize significant tax savings.
The new rules significantly limit income splitting opportunities with related individuals, except in specific situations such as retirement and death. For example, the new rules impose reasonableness tests on dividends to specified individuals. Reasonableness tests consider factors such as the labour contribution and the capital contribution of the specified individual. As a result, the benefits of income splitting are largely no longer available to those family members that are not involved in the business.
Of note, this affects only situations where the family shareholders are not involved in the business. If you can demonstrate that these family members are involved in the business, income splitting benefits are still available to you. As well, if there are family members that potentially may be involved in your business, setting them up with non-participating shares in case can still be a good strategy.
As such, the new rules significantly limit the tax planning advantage of income splitting to specific situations. Income splitting with non-participating family members may no longer be a good reason to incorporate.
It is now very important to consult with a tax advisor well versed in the application of the new rules.
Other reasons for incorporating remain unchanged by the new rules. These include:
– Flexibility with respect to remuneration planning;
– Flexibility with respect to compensation models (eg. private health services plans, company paid life insurance and stock option plans);
– Wider scope of expense deductibility;
– Ease of raising capital, and
– Corporations live forever.
In summary, the recent taxation changes should not dissuade you from incorporating. Unless the sole reason for incorporating was income splitting with non-participating family members or setting up an investment company, in most other cases, these new changes, while making income splitting less accessible, do not hinder the other advantages of incorporating.
Disassembling an existing corporate structure in response to the new rules may not make sense either. Taxation rules can and will change with the current flavour of government. However, it would not be prudent or wise to adopt a reactionary approach. Place your trust in a well-developed and thought-out strategy which allows flexibility with changing scenarios, established through close consultation with your tax advisor.
Whether you are considering incorporating, winding down, or a corporate reorganization, contact us to develop a plan that is right for you.
This newsletter has been written in general terms to provide broad guidance only. It should not be relied upon to cover specific situations and you should not act upon the information contained herein without obtaining specific professional advice. Please contact our office to discuss this information in the context of your specific circumstances. We accept no responsibility for any loss or damage resulting from your reliance on the information in this newsletter.