To incorporate or not to incorporate?

That is the question. As financial professionals, we often encounter business owners who aren’t aware of the advantages of incorporating their companies.

Many small business owners in British Columbia are perplexed over the issue of whether to incorporate. The advice they receive isn’t always clear, and, to be fair, many entrepreneurs are devoted to growing their businesses and not the minutiae of tax planning.

But they would be wise to scrutinize their financial affairs to see if they are missing significant tax-planning opportunities.

Small business owners are often told to ignore incorporating their businesses and instead pay themselves enough of a salary to buy RRSPs to offset the high levels of income tax imposed on their businesses. For this to occur, the RRSPs must be dependent on earning an income from the prior year as a salary and bonuses. The current maximum allowable RRSP contribution limit is $22,450 for 2010 and business owners would need an annual salary of $124,722 to achieve this level.

{advertisement} A better question to ask is not whether one can maximize RRSPs, but rather is there a better way to maximize tax savings as a business owner? The answer may lie with the benefits of transforming a small business operation from a sole proprietorship or partnership into an incorporated business. The reasoning relies on some basic assumptions:

» There are consistent earnings by the business owner in and around a level of $100,000 or more
per year.
» The business is a Canadian-controlled private corporation (CCPC).
» A degree of earnings does not need to be withdrawn from the business for personal income and can remain as retained earnings.

Pay Lower Taxes

Instead of a sole proprietorship or partnership, incorporation allows the business owner to receive dividends instead of a salary, resulting in a lower rate of tax paid by the owner on those earnings by 30 percentage points. In addition, in lieu of salary, the employer’s and employee’s portions of the Canada Pension Plan will no longer be paid by the business, thus reducing expenses paid by the corporation. However, this will reduce or eliminate future CPP benefits at age 65.

The corporate tax rate for small businesses in B.C. is 13.5 per cent. The highest marginal tax rate for earned income for individuals in B.C. is 43.7 per cent. If a small business owner examines the tax savings of paying a dividend versus a salary at the highest marginal tax rate, the tax savings
clearly favour incorporating. However, we strongly urge you to consult a qualified tax accountant
before proceeding.

Assuming the above example is achievable from a tax standpoint, incorporation has additional benefits, including:

» Limited liability to the personal assets of the business owner
» Investment strategies using assets of the business
» Income-splitting opportunities for the owner and spouse

As noted above, one of the reasons for incorporating concerns the business having surplus revenue that is not being paid out as income. With an incorporated business, one can leave excess funds in the corporation to be invested. As the successful business grows over time, so will the investment assets. At some point, owners will likely use these assets for retirement income as they are no longer contributing to RRSPs and the CPP.

In addition, they may also want to leave their heirs, i.e. their children, as much of the estate as possible. From an estate-planning perspective, the assets in the corporation will be subject to corporate and personal taxes upon death of the business owner. To avoid a great deal of these taxes on the estate, one can maximize the after-tax value of these corporate investment assets using insurance-based products.

One strategy is to create an investment holding company (Holdco) and transfer the excess investment assets from the active business corporation (Opco) tax free. With the corporate investment assets held in Holdco, investment income and capital gains will be subject to corporate income taxes. However, upon the death of the last surviving Holdco shareholder, significant tax liabilities will be incurred.

Insurance Can Help

To avoid this, the business owner can create a tax-free investment vehicle within Holdco and allocate a portion of the corporate investment assets in excess of those needed for retirement. This will be done with proper retirement planning to ensure that the business owner is still receiving sufficient retirement dividend income from Holdco.

The tax-free investment vehicle is a universal life policy. It allows the investments within the life insurance policy to be sheltered from corporate income taxes over the life of the contract. Upon the death of the business owner, the life insurance policy pays the Holdco a tax-free death benefit, and provides the proceeds to pay out as a tax-free capital dividend to the beneficiaries of the estate.

This strategy is very effective in providing the right amount of retirement income and ensuring that
the hard-earned business assets go directly to the heirs of the estate tax-free in a very cost-effective manner.

In summary, we asked the taxing question, “Are there advantages to incorporating a small business?” The simple answer is yes. However, we stress that you seek advice from a tax-planning specialist with corporate tax planning expertise and from insurance specialists.