8/23/22, 2:27 PM Tax Considerations

Tax Considerations.
Creating a corporation can have several tax implications for the client. Some of these aspects may
be positive or negative for the client.

Tax Benefits.
Corporations have access to several tax benefits and tax planning opportunities that are not
available to other forms of business organizations. The extent of these benefits depends on the
comparative corporate and individual tax rates in particular jurisdictions (provincial and
territorial) as well as on the type of income earned. Some of the tax-related benefits are examined
below.

Lower tax rates.

Canadian-controlled private corporations (CCPCs) enjoy a considerable tax rate reduction in the
form of the small business deduction (SBD) on income derived from an active business carried on
in Canada. Other preferential tax treatments include the general rate reduction in federal income
tax and provincial or territorial tax abatements.

Tax deferral on personal income.

Earnings in a corporation do not attract personal tax until they are paid out to its owners
(shareholders). The value of a tax deferral depends on how long funds can remain in a
corporation; as soon as funds are withdrawn from a corporation for personal consumption, they
are generally taxed at the corresponding personal income tax rate. Due to the widening gap
between the higher personal tax rate and the corporate tax rate on active business income, the
tax deferral benefit of retaining profits in a corporation has increased. The additional cash flow
retained within the corporation, as a result of the lower corporate rates, may be used for
reinvestment in business or other investment opportunities.

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Illustration 1: Tax deferral on personal income.

Let's take a example very simple: Jonathan created his corporation a few years ago. The
annual business income of the corporation is $80,000 and the annual business expenses
are $10,000. Jonathan's annual compensation (salary or dividend) is $35,000, which is
enough to cover all his personal expenses during the year.

After 3 years of exploiting his business, Jonathan would have been taxed personally on
$105,000 (i.e. 3 x $35,000):

If Jonathan had not incorporated his business, after 3 years, he would have been taxed
personally on $210,000 (i.e. 3 x $70,000):

In conclusion, Jonathan has saved a significant amount of personal tax over the last 3
years. For this conclusion to be true, he has to take a compensation in the corporation that
is lower to the net business income (lower than $70,000 in this example).

Tax deferral on bonus.

The corporate entity allows the taxpayer the flexibility to withdraw funds for personal
consumption when required, thereby increasing tax planning opportunities. For example,
shareholders of a corporation can achieve an annual income deferral through the use of bonuses.

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Remuneration in the form of bonuses accrued in the taxation year of a corporation will normally
be deductible to the corporation provided they are bona fide obligations and are paid out at some
time during 179 days after the year-end. As the individual shareholder will be taxed only in the
calendar year he or she receives the bonus, a deferral of income tax can be achieved.

There are also some other factors to consider, such as the risk of exposing retained earnings to
creditors in an economic downturn or the possibility of losing such earnings if the corporation
were to become insolvent. However, there are strategies to address such risks if business owners
are diligent about annual tax planning.

Illustration 2: Tax deferral on bonus.

Roberta Smith’s clothing business – with a September 30, 2021 year-end, had an
extraordinarily good year, with a net income of $145,000 after paying Roberta $50,000 of
salary. By declaring a Bonus Payable of $45,000 at the corporate year-end, the business
only had to pay corporate tax on $100,000 ($145,000 - $45,000 Bonus), and Roberta only
had to report regular salary of $50,000 in 2021, as the bonus was not actually paid until 179
days later – falling in the 2022 calendar year.

After the bonus is paid out, the corporation does have the option of declaring a bonus
payable the next year, which will effectively allow the corporation to defer the income tax
for almost six months at a time for several years.

With the lower personal tax rates on eligible dividends, the overall tax cost of retaining
after-tax corporate earnings in the business (and paying them out later as dividends) has
become a much more tax efficient strategy. In addition, the declining general corporate tax
rates over the last several years have increased the tax deferral benefits of leaving funds in
the corporation.

Tax-free transfer of assets to the corporation.

Business assets that were used by self-employed individuals can be transfered on a tax-free basis
to the corporation by using Section 85 of the Income Tax Act.

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Section 85 rollovers are complex and out-of-scope of this course. They are however included in
the curriculum of Level 2 - Advanced knowledge in corporate income tax of H&R Block Tax
Academy.

When section 85 rollovers are well executed, shareholders may be able to transfer assets to their
corporation without including revenues in their personal income (capital gain or depreciation
recapture). Under some circumstances, they may also be able to withdraw tax-free amounts from
their corporation in compensation of the assets they transfered.

Income splitting.
There are income splitting opportunities available through a corporate entity that are not
available with an unincorporated business entity; however over the past few years these tax
planning opportunities have become more restricted.

Income splitting involves reallocating corporate income among family members. For example, in
the case of an owner-managed corporation, income splitting allows (with certain conditions) the
owner-manager to split income with family members in lower personal tax brackets to take
advantage of their marginal personal tax rates and personal credits. This can be achieved by
employing family members in the corporation and paying them salaries, wages and/or bonuses
based on the fair market value of their employee services. Another strategy is to make other
family members who are above 25 years old or a family trust as shareholders of the corporation.
This provides the opportunity to distribute dividends to family members who may be taxed at a
lower rate than the owner-manager.

Note.
Under the Tax on Split Income (TOSI) rules introduced in 2018, income splitting rules have
become much more stringent whereby the old “kiddie tax” now can apply to adult children
and spouses. Therefore it is important to properly plan out income splitting strategies to
ensure the dividend received by the lower income family member is not taxed at the
highest marginal tax rate.

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Business Forms.
Refer to Tax On Split Income (TOSI) Checklist on Contact to determine if split income
will be subject to TOSI and taxed at the highest marginal personal tax rate.

Succession/Estate planning.
Succession planning is of particular importance for the owner-managed corporation, as the
ownership in this type of incorporation is more closely-held and impacts the livelihood of family
members, other shareholders and even employees. Succession planning cannot begin soon
enough and should be considered in the incorporation decision-making as the business is likely
to impact the business owner’s estate in the event of unforeseen events such as a terminal illness
or even death. Succession planning issues to be considered include:

Continuation of the business: What plans does the business owner have for the business upon
retirement or any unforeseen events? Is there a likelihood that family members will take over
the business or will the business be sold to a third party?
Do the business assets have value that may attract potential buyers?
Will the business owner have enough capital gains exemption room to lessen the impact of
income taxes when the business assets are transferred or sold?

When taxpayers die, there is a deemed disposition of all their capital property, including the
business assets for self-employed individuals and the shares of a corporation for individuals who
had incorporated their business. Those tax consequences have to be considered when advising
clients on incorporating their business.

Income leveling.
The concept of “leveling income” is to control the level of salary, bonuses and dividends received
on a year to year basis to avoid high- and low-income periods, particularly in a business whose
profits fluctuate from year to year, as well as to take advantage of low marginal rates of lower tax

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brackets to reduce tax liability. Incorporation is one of the best ways individuals can control when
to receive taxable income, either in the form of salaries or dividends.

The general idea with income control is that during high earning periods, an individual takes
advantage of tax deductions and defers some income to avoid paying tax at high rates. During the
lower earning periods, that same individual takes in extra income to the extent of a lower income
bracket limit, so as pay less tax. Note that this strategy is effective when the individual remains in
the same tax bracket, because any additional income that puts him/her in a higher tax bracket
results in higher taxes.

Controlling income also involves remuneration planning for the immediate future of the
incorporated business, particularly if the business owner plans to expand ownership of the
corporation by attracting outside investment (i.e. shareholders). If additional shareholders are
being considered, an income distribution structure that attracts investors should be established.

Note.
Securities laws are complex, therefore a lawyer will be required when issuing shares or
adding new shareholders.

Illustration 3: Income leveling.

Variable Contractors is an incorporated business that has considerable fluctuations in
income. During an interview with Steve Variable, the owner-manager, Steve indicates that
the business’ net income can be as high as $150,000 one year, but as low as $25,000 other
years. If the funds from the good years are not required for personal expenses, Steve could
use the corporation to lower the overall tax burden in those high income earning years by
paying an annual average salary of $87,500, thus leveling income.

Lifetime capital gains exemption.

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The corporate structure permits access to a lifetime capital gains exemption of up to $913,630
(2022) on the sale of certain small business shares that meet the definition of qualified small
business corporation shares (QSBC) and the first $1,000,000 on the sale of qualified farm property
or fishing property.

This exemption, if available, means that the first $913,630 (2022) of gain on the sale of QSBC
shares and the first $1,000,000 (2022) of gain on qualified farm/fishing property is not taxed at all.

The shares of a Canadian holding company also qualify if substantially all of its assets are shares
or debt of other connected small business corporations. For more on the capital gains exemption
rules and conditions, refer to Appendix B.

Tax Disadvantages.
Although there are many tax benefits of incorporating a business, we have to keep in mind some
negative tax consequences that may arrise.

Limited use of losses.

A shareholder cannot use a corporation’s losses to offset personal income, as a corporation is a
separate legal entity reporting its income and losses on a T2 return. On the other hand, losses
generated through an unincorporated business, such as a sole proprietorship, may be used to
offset income from other activities. However, there may be situations such as in insolvencies
where shareholders may be able to claim business investments losses on their personal income
tax returns. Business investment losses are examined in detail in the Advanced Topics in Corporate
Income Tax, Allowable Business Investment Losses (ABIL) course.

No depreciation expense in the year of transferring the assets to the

corporation.
In the tax year that self-employed individuals transfer their business assets to their corporation,
they will not be able to claim a depreciation expense on their personal return. This will
particularly affect taxpayers that incorporate their business late in the tax year, as they will have
several months of self-employed revenues but no depreciation expense.

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No personal credits for corporations.

Unlike individuals, corporations pay income tax on their first business income because they do
not have access to various personal credits (for example: basic personal amount, age amount and
medical expense credit).

Thus, even though a corporation may be taxed at a lower rate on its business income, the total tax
burden of the taxpayer may be lower in some cases if the business revenues are taxed at a
personal level.

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