I’ve written about incorporation before but here is my update for 2019.
The process of incorporating means to form a separate legal entity from yourself. This corporation will be responsible for filing its own taxes. It will have to have a bank account, and you will have to keep separate, often more complex accounting records.
There are three reasons why someone would want to incorporate their business:
- Protection from liability risk
- Selling the business at a future time
- Income splitting / tax reduction
Nothing has really changed for the first two. It’s number three that is now an ongoing concern. Before January 2018, if your company earned a lot of money and you wanted to pay less tax, rather than taking it all as a salary yourself, you could issue shares to a spouse or adult child that paid dividends or you could defer payment to the future (more on that below).
Issuing shares to a university-bound 18 year old could result in paying dividends that magically covered the exact costs of tuition, room and board. The student likely wasn’t earning money or had enough tuition credits to deduct, so there was no tax paid on those dividends.
What changed in 2018 is that the CRA is now asking for justification for paying dividends (they’ve always asked for this for wages). Did that person invest a significant amount of money in the business? Did they perform specific tasks in the business or work full weeks? The CRA says the compensation has to be reasonable in accordance with their investment. Given that there’s never been a test for what a “reasonable” return on private company shares would be, this presents a lot of possible issues.
If you want to use this tactic to save taxes, you need to be able to prove that the dividend you pay out now is reasonable. Have they invested capital, such as someone who invests $2M in a manufacturing business or did they work 40 hours a week? If they stay at home and couldn’t find the building on a map, the CRA wants to know what they did to earn it. That test never used to apply to dividends.
Income splitting saved a number of people a considerable amount of tax, but the CRA is stepping in to see what they can do to prevent it from being done fraudulently.
The challenge is that ‘reasonable’ is not defined and it’s going to take someone taking the CRA to court to narrow the definition. Unless you want to be that guinea pig, dividends to people who may not be quite as involved in the business are probably a bad idea.
The simplest way to pay less tax now is to defer the income.
Let’s say you’re a consultant who has a great year that’s unlikely to repeat. Maybe you made $1M. If you’re self-employed, you have to declare the entire income for the year. However, if you’re incorporated, the company can pay you your salary over time. The highest tax rates are for income over $220,000 (Ontario). If you want to avoid that almost entirely, the corporation could pay you over five years. If you’d like the money sooner, the corporation could split the income over 2-3 years. This would be a great solution for someone who is winding down their career or simply looking to work a little less in the coming few years.
If you have any questions about the benefits of incorporating, please get in touch.