Entrepreneurs are often so focused on their expertise and wares that they fail to adequately plan how to structure the business itself. In particular, a failure to make use of a corporation and to careful monitor its operation can lead to significant forgone benefits and potential liabilities.
Though not exhaustive, this list covers the bulk of the most important tax and estate issues most entrepreneurs may face. Five items are presented below, with a further five in next month’s column.
1. Failure to incorporate – Slowing business growth
If a business is run as a sole proprietorship, the owner of the business will be personally taxed on the income, ranging from 39% to over 50% at top bracket depending on province. After-tax, this means that the amount available for reinvestment in the business annually is almost half or less than what was originally earned.
By comparison, a small business corporation is entitled to a flat rate of tax below 20% on its first $500,000 of active business income. (The provincial tax threshold is only $400,000 in Manitoba and Nova Scotia.) When the accumulated income (the retained earnings) is reinvested in the business, each dollar the business earns will generate in excess of 80 cents in useable capital.
2. Failure to incorporate – Losing tax-free capital gains value
A business earns income from year to year, and it also grows in value itself to the extent that earnings are retained within it. If the business is run as a sole proprietorship, upon sale the owner will have to pay tax on the growth in the business’s value, which is the capital gain.
By comparison, every person is entitled to a $750,000 exemption from tax on the capital gains associated with small business corporation shares. (Heading up to $800,000 in 2014, and indexed annually thereafter.) Accordingly, if the same business is run as a qualifying small business corporation, the owner can save in the area of $150,000 or more in tax on the disposition/sale, including a deemed disposition on death.
3. Failure to incorporate – Exposure to creditors
Launching a business is often a risky endeavour in at least two respects:
- Exposure to banking and trade creditors who have provided financial backing to the enterprise
- Exposure to liability claims under contract and tort (eg., negligence) in the normal course of business operations
If a person runs a business as a sole proprietor, both of these liabilities will be imposed directly upon that person, and his/her assets will be subject to claim by such creditors.
A corporation is a separate legal entity from the shareholders who own it, and therefore liabilities that arise within the corporation do not flow up to the owners of the corporation, with some fairly rare exceptions. Unless the shareholder has executed personal guarantees on behalf of the corporation or has otherwise personally acted in a way to attract liability, the only personal asset at risk for the shareholder will be the investment in the corporation itself.
4. Holding investment money in a small business corporation
The small business tax rate is only available on a corporation’s active business income, being earnings generated from its actual commercial activities. By contrast, passive income arises out of excess corporate cash being placed in portfolio investments, including bank interest, GICs or marketable securities.
Passive income is taxed at the regular corporate rate, and it is also charged an additional refundable tax that results in a total immediate tax payment close to 50%. Rather than face these complications, a shareholder may be content to dividend that excess cash, pay the tax on the dividend, and invest the net funds personally.
Alternatively if the owner would prefer to defer making those dividends, careful attention should be paid to the type of returns generated on those continuing corporate-held investments. Generally this means an inclination toward tax-deferred returns such as unrealized capital gains, or making use of the sheltering capacity of exempt life insurance in qualified circumstances.
5. Paying personal expenses out of a corporation
A corporation is a separate legal entity from the shareholders who own it.
A small business owner who ignores this fact and pays expenses with corporate money is in for a rude awakening. Such payments will likely be deemed as shareholder benefits, and be taxed at the shareholder’s marginal tax rate.
The proper procedure would be to dividend the money from the corporation to the individual. The net effect of the gross-up and tax credit procedure is an effective tax rate about a third less at top bracket, and significantly lower at more modest bracket levels.
Here is what is coming in Part TWO:
6. Not protecting wealth using one’s spouse
7. Failure to protect against the loss of a business to taxes at an owner’s death
8. Having no exit strategy from a business
9. Paying for business needs insurance personally rather than corporately
10. Double taxation of capital assets