Incorporation

Corporation

Incorporation is a legal process creating a new legal entity which will have rights and obligations to enter into all contracts including employment contract and leases, operate its bank accounts and prepare corporate incomes tax returns. Once your business is incorporated, the assets and liabilities of the corporation are separated from your assets.

Incorporation from a Sole Proprietorship

All of the assets of a sole proprietorship can be transferred to the corporation on a tax-deferred basis, commonly known as section 85 Roll-over. In return, the corporation will give the sole proprietor a promissory note, assume the liabilities or issue shares, equal to the value of the assets. A sales agreement must be in place between the sole proprietor and the corporation. This agreement will provide a list of the properties transferred and consideration received by the sole proprietor. It is recommended to retain a business valuator to determine the value of the transferred assets. There also may be an HST implication. Depending on the type of assets are being transferred, HST may be payable on the transfer of assets from the sole proprietor to the corporation. In most of the cases, it is recommended to file a joint election by the sole proprietor and the corporation so that HST payment will be deferred until the assets are sold to a third party. Timing of incorporation is another critical consideration. A sole proprietor who transfers his or her assets to a corporation will have a deemed year-end upon the cessation of the business. Such that he or she will not be able to claim capital cost allowance in that year. It is advisable to incorporate the company shortly after the calendar year-end to claim the full capital costs amount. Once incorporated, the new corporation has 53 weeks to choose the year-end. For tax planning purpose, July, August or September is selected for a corporation’s fiscal year-end.

Holding Company

Once the corporation becomes successful and holds a large sum of cash, it is advisable to create a holding company (Holdco) to own the shares of a corporation and transfer earnings to Holdco by way of tax-free dividends. Having a Holdco will reduce the risks of the shareholders from a potential legal proceeding. In other words, a Holdco provides greater certainty to the small business owners.

Limited liability

Incorporation limits the liability of shareholders. Generally, the shareholders are not liable for the corporation’s debts and liabilities unless personal guarantee or collateral is provided.

Tax Deferral

With a corporation, you can enjoy lower tax rates. You can withdraw only cash needed for personal expenses for that year, avoid the high-income tax rate. In other words, business owners may hold the funds until their marginal tax rates are low. In Ontario, the highest marginal tax rate for an individual is 50%, and the tax rate for a small corporation is 15.5%. Deferring taxes will have a compounding impact on your investments in the corporation. Without a corporation, the business owner is obliged to withdraw all the money and taxed in the same year.

The Small Business Deduction (SBD)

Low corporate tax rate and deferring taxes are made possible due to the Small Business Deduction (“SBD”) which is only available to Canadian Controlled Private Corporation (“CCPC”). Income earned by a CCPC should qualify as active business income. In other words, a business owner cannot take advantage of a low tax rate for the income earned from investment. Another important point the business owner needs to keep in mind is that SBD is limited to $500,000 and that SBD must be shared with associated corporations.

Income Splitting Opportunities

Incorporation avails you to split income with lower income family members commonly known as dividend sprinkling. The business owner must be cautious that any payments made to a minor child will be subject to the highest tax rate known as Kiddie Tax.

The Lifetime Capital Gains Exemption (“LCGE”)

You can take advantage of a significant tax break on the capital gains when you dispose of certain CCPC shares. In other words, your incorporated business may be sold on a tax-free basis up to LCGE limit. Current LCGE limit in 2020 is $883,384. Note that a purchaser might want to lower the purchase price given that LCGE might be available to you. You and your family member may be able to claim LCGE individually. For instance, for a family of four, the business owner may be able to claim LCGE over $3.2 million (0.8mil x 4 family members).

Employee Benefits

Individual pension plan (“IPP”) is a defined benefit pension plan that a corporation can be set up for key employees. An IPP is best suited for employees who earn a substantial amount of employment income. As the business owner is also considered an employee of the corporation, the business owner can benefit from this plan. The annual contribution room for IPP can be higher than the yearly contribution limit for RRSP. The contribution to IPP is tax deductible, and it is only taxed when the funds are withdrawn. Like most of the pension plans in Ontario, IPP is exempt from seizure or execution. In other words, IPP is protected from creditors.

Health Spending Account (“HSA”)

HSA is only available to the incorporated business. HSA is a contract between the business owner and the corporation. Canada Revenue Agency allows the corporation to reimburse your medical expenses. The reimbursement is tax deductible for the corporation and tax-free for the business owner. In short, the business owner withdraws money from the corporation without tax implication.