The Canada Revenue Agency (CRA) classifies an incorporated employee as a personal service business (PSB). According to CRA you are an incorporated employee if you would be reasonably considered an employee of the company you are consulting for. If this is the case, you lose out on the small business deduction and get taxed at the higher general corporate rate, and you lose the ability to deduct a number of business expenses. To get any value from a corporation, the benefits have to outweigh the costs.
Disadvantages of incorporating:
- Higher start-up costs
- More complex structure
- Business losses cannot be flowed through to the shareholders
When to pull the trigger? Five signals to look out for:
- Are you earning more money than you need to fund your lifestyle?
- Do you want to limit your personal liability?
- Are you getting into the higher tax brackets and have family members in the lower ones?
- Is your business income expected to continue to grow, as with the case of many professionals?
- Do you want to explore more advanced strategies to fund your retirement?
Are You Getting The Full Value Out Of Being Incorporated?
The great wall of tax. Imagine that you and your corporation are on opposite sides of this wall of tax. When money crosses the wall from being earned in your corporation to you, it triggers tax up to your highest tax bracket (of 46.41 percent or more).
Incorporating may be good for your investments
If you don’t need your income personally, keep it in the corporation. You save paying tax on it at the personal level, and by investing inside the corporation you now have more money available. It just makes sense to invest any surplus inside your corporation.
The Refundable Dividend Tax On Hand (RDTOH) account is a useful tool for this. This investment income generates a refundable tax which is tracked in a RDTOH account. This is a notional account, and when the corporation pays out taxable dividends to its shareholders, the corporation gets a refund.
Would you like tax-free dividends in retirement?
A Capital Dividend Account (CDA) is another useful tool, and all private corporations in Canada qualify for one. This is another notional account, but one where the corporation can distribute funds to shareholders on a tax-free basis by paying out a ‘capital dividend’. If there is an amount in the CDA, a capital dividend can be paid. This can allow the insurance death benefit to come out of your corporation tax free and into your estate for your beneficiaries without incurring taxes.
The benefit is corporate tax deferral at a lower rate. You can invest in:
- Tax-sheltered life insurance.
- Corporate class mutual funds.
Buying corporate class funds in your corporation utilizes the tax environment more effectively and sets up tax savings where they did not exist before. You have the ability to change or re-balance your investments without triggering a taxable event and you can continue this until you withdraw money from the structure, at which point you can choose to receive cash flow in one of three ways: as capital gains or losses, dividends, or return of capital.
Incorporating can be good for your insurance.
Eight benefits of having insurance inside your corporation
- More coverage for less after tax cost: Generally the premiums you pay on a life insurance policy cannot be deductible for tax purposes. Because of this it may be worthwhile having the insurance inside the corporation, so the corporation pays the premiums. Often the corporation is in a much lower tax bracket than the owner or shareholders, and this can represent a significant tax saving as it has more after tax dollars to invest. If the shareholder is at a 46.41 percent tax bracket, they have to earn about $1,900 to pay a $1,000 insurance premium personally, whereas a corporation paying tax at the small business rate in Ontario of 15.5 percent would only need to earn an income of $1,200 to pay the same premium. When buying insurance through your corporation, you can buy more coverage for the same amount of before tax earnings using ‘cheaper’ corporate dollars. If you don’t need your money right away, keep it in the corporation and defer the 30.91 percent.
- More tax-deferred growth: Investing inside the corporation allows you to invest more than the after tax amount you could invest personally. The result is you can dedicate more money to the investment portion of a permanent policy resulting in more tax-advantaged growth inside the policy.
- Health and age issues: When there is a material difference between the ages or the health status of the shareholders, it may be considered financially unfair for personal ownership of the insurance policies, especially if the younger or healthier person has to pay the premiums on the older or unhealthier shareholder’s policy. Putting it all in the corporation helps alleviate this as the cost of the premiums can be split based on the ownership of interests of the shareholders.
- Collateral loan: If the insurance policy has cash surrender values, the policy can be assigned to a financial institution for collateral, allowing the corporation or a shareholder to borrow against it. The funds can be used in a number of ways such as expanding the business, buying assets or redeeming shares of a shareholder. There are a number of risk factors in leveraging a policy this way, and it should be done only with professional advice.
- Buy/sell funding: When you have more than one owner in the corporation you can use the insurance paid by the company to be an iron clad way to fund your buy/sell agreement.
- Use of the tax-free dividend account. The corporation can choose to pay the proceeds to the surviving shareholders or the estate of the deceased tax-free.
- Tax deductible disability insurance.
- Protection from personal creditors.
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