How do I pay less tax (legally)?
Now that the year has closed and we are reflecting on our businesses in preparation for our tax return, some may start to feel that dull ache in their stomach begin to grow. But paying tax is a good thing [it means you made a profit]. However, there are ways to make a healthy income and pay less tax. I’m sure you have heard of the word “Incorporation”.
Let’s look at the Pros and Cons to determine if this is something that would benefit you:
- Liability – Having a separate legal entity ensures creditors or legal actions go against your corporation and its assets, not your personal assets. (There are exceptions, such as personally guaranteed loans, government tax obligations and payroll deductions, among others.)
- Personal Income – You can choose the most tax-efficient way to pay yourself, including dividends, salary, bonus or a combination. You can even use dividends as a way to split income with your spouse if he or she is a shareholder in your Canadian-controlled private corporation (CCPC).
- Tax Shelter – If you don’t need all business earnings for personal income, you can leave them in the business, deferring personal taxes on withdrawals and possibly enjoying an approximately 15-per-cent preferred tax assessment on the first $500,000 of profit in CCPCs. Personal rates start at 20% and can be 46% or more.
- Spread the Wealth – Your business has tax flexibility from which you may personally benefit. If you sell shares in your CCPC, capital gains could be tax-free up to $750,000.
- Flexibility – the rules for sole proprietors are fairly rigid. Incorporated companies have many more options open to them for tax planning and also attracting investors.
- Incorporating costs money. You can do it on your own, technically, but it’s more advisable to get the help of a lawyer and an accountant. It’s just as expensive to “fix” your articles of incorporation as it is to do them right the first time.
- Incorporated entities must file more paperwork, such as separate tax returns, an annual return, one-time articles of incorporation and notifications of share sales, moves or changes of directors.
- Losses in an incorporated company can’t be personally claimed. A failed startup can only be “written off” personally to the amount you had invested, not the accumulated negative earnings.
Filing fees and professional fees for an incorporation can range from $800 to $2,800, so the cost itself maybe be prohibitive for some. If you are starting a business, with low liability and legal risks, and are likely to incur losses at first, postponing incorporation may make sense, primarily for the cost savings and tax advantages. As your business grows, the need to incorporate may become greater. So revisit the business case for incorporating periodically.
As for the accounting side, as long as you remain a sole proprietorship, all your profits will be taxed as personal income, which could involve tax rates potentially as high as 46 per cent. If you run an incorporated business at a loss and then shut it down, you can’t claim the business’s losses personally – they are gone. All you can claim personally is money you lent or invested in the business as stock or loans, whereas, in a sole proprietorship, you may be able to claim the full amount of your business losses against other income.
So, when is it time to incorporate? The answer is: It depends. To start looking at it seriously the very general rule I share with my clients is “When your business starts to make a profit of more than you need for your personal monthly expenses”.