To incorporate or not to incorporate, that is the question.

• Author: Kirby, Tim
• Position: Tax Law

Most people "know someone" who allegedly cut their annual income tax bill in half by incorporating their business instead of slogging away as a sole proprietor. While there are clearly some tax benefits associated with carrying on business through a corporation as opposed to personally, these benefits are not automatic and will only be realized in the proper circumstances. In addition, there are various non-tax considerations that should be taken into account before deciding to incorporate.

The first $300,000 of active business income earned by a "Canadian-controlled private corporation" (CCPC) is subject to a special, low rate of corporate income tax. (Most corporations incorporated in Canada will be CCPCs, provided they are not controlled by non-residents and their shares are not publicly traded.) A corporation may then distribute its after-tax income to its shareholders in the form of dividends. Shareholders will then pay personal income tax on the dividends received in a year. Shareholders who receive dividends, however, are entitled to a dividend tax credit, which approximates the amount of corporate income tax that has already been paid. Together, this low rate of corporate income tax and the dividend tax credit are intended to result in the first $300,000 of active business earned by a CCPC and distributed by dividends to the corporation's shareholders being subject to the same amount of tax as if the business income had been earned by an individual personally. The federal budget released on May 2, 2006 proposes to increase this $300,000 limit to $400,000 for the 2006 and subsequent taxation years.

If the combination of the low rate of tax and the dividend tax credit result in the first $300,000 of active business earned by a CCPC being subject to approximately the same amount of tax as if it had been earned by an individual personally, then where does the so-called income tax "benefit" come into play? The benefit is a deferral of tax rather than an absolute tax savings, as no personal tax will be paid on corporate income until such time as the corporate income is distributed to its shareholders in the form of dividends. This benefit will only be realized in circumstances where the shareholders do not require all of the corporation's income for their personal needs as the incidence of personal income tax is only deferred while the corporate income remains within the corporation. Accordingly, the ability to defer the incidence of...