This week’s question from our portal “Ask Us Anything” comes from someone who wishes to remain anonymous.
When is the right time to start planning for tax strategy in a business? Do I need to make a certain amount of money first?
Well, the simple answer is: yesterday!
Most business owners think they need to be of a certain size to start planning for taxed and executing on complex and strategic tax planning.
However, I can promise you that even the smallest business can benefit from some simple tax strategy – and the benefit is that you get to keep more money in your pocket earlier!
The ideal time to kickstart your tax strategy isn’t linked to hitting a specific revenue or profit milestone; it’s about getting in the game from the very inception of your business journey. Whether you’re a start-up or a seasoned player, being proactive with your tax planning is your secret sauce for financial success.
Now, let’s dive into the nitty-gritty, considering tangible examples and figures while exploring the unique tax implications for incorporated and unincorporated businesses…
Sole Proprietors and Corporations
Here’s a simple one that most people are familiar with.
If you’re starting a business in Ontario, you realistically have a few options:
- You can operate as a Sole Proprietor. You do not need to do anything to be a sole proprietor. This is the default when you start a business and do not incorporate.
- You can choose to incorporate the business as a Corporation.
One of the key tax differences between having a corporation and being a sole proprietor in Ontario is the tax rate.
A corporation pays a lower tax rate than a sole proprietor on its net income. For example, in 2023, the combined federal and provincial corporate tax rate for a small business in Ontario was approximately 12%, while the marginal personal income tax rate for a sole proprietor can range from 20.05% to 53.53%, depending on their income level.
This means that a corporation can save more money on taxes and reinvest it in the business or pay dividends (or profit) to its shareholders/owners.
Let’s put this into perspective using an example:
- A sole proprietor that generates $150,000 in income would pay approximately $50,000 in taxes.
- A corporation that generates $150,000 in income would pay approximately $18,000 in corporate taxes.
Keep in mind, the above is not taking into account paying the owners/shareholders via salaries or dividends, as there are other tax consequences once you do that.
However, you can see that there’s a massive difference of about $32,000 saved already! As the income levels start increasing, this difference continues to grow and grow.
Small Business Tax Deduction
The small business tax deduction is a benefit for small businesses in Ontario that allows them to pay the 12% tax rate on their active business income instead of a much higher corporate tax rate.
Active business income is the income you earn from your regular business activities, such as selling goods or services.
If your business is a Canadian-controlled private corporation (CCPC), you can claim the small business tax deduction on the first $500,000 of your active business income in a tax year.
The tax rate for this income is 12% for the first $50,000 in active business income. After the $500,000 limit has been exceeded, the corporate tax rate jumps to about 15% or more.
Canadian Controlled Private Corporation
Just because you incorporate and you generate less than $500,000, it doesn’t mean that your tax rate suddenly drops down to 12%. The 12% threshold only applies to companies that meet the requirements of being a Canadian-Controlled Private Corporation (CCPC).
A CCPC is a company that has at least 50% of its shares owned by resident Canadians.
Therefore, if you have a lot of foreign investment in your company or if you move out of Canada for a long enough period of time, you might lose your preferred tax rate.
There are also a few other reasons why you may not be eligible for CCPC status or the Small Business Tax Deduction. Always speak to an experienced professional if you have questions about the tax rate that might apply to you.
Planning is Everything!
Now that we’ve talked about the basics – Sole Proprietorships vs. Corporations – let’s get a little more complicated… The below strategies all assume that you have a Corporation in place so that you can implement these strategies:
The Estate Freeze
An estate freeze is a tax planning strategy that allows you to lock in the current value of an asset, such as your family business, and transfer the future growth to your beneficiaries, such as your children or grandchildren, at the locked-in value.
This way, you can reduce the tax liability that will arise when you die and pass on your assets to your heirs. Instead of paying the capital gains tax at the value of your business in the future, you can pay capital gains tax on the locked-in value.
An estate freeze can also help you retain control of your assets and provide you with a source of income during your lifetime.
The Butterfly Transaction
A butterfly tax transaction is a way of splitting a corporation into two or more corporations without triggering any tax consequences.
It is often used when shareholders of a corporation want to go their separate ways or when a corporation wants to separate its different lines of business.
A butterfly tax transaction can be done in different ways, depending on the situation and the goals of the parties involved. However, the basic idea is that the original corporation transfers some or all of its assets to one or more new corporations in exchange for shares of the new corporations.
The original corporation then distributes those shares to its shareholders, who end up owning the new corporations.
The transfer of assets and shares is done in a way that meets the requirements of the Income Tax Act, so that no capital gain or loss is recognized by the original corporation or its shareholders.
Split your income with family members:
If you have family members who are in a lower tax bracket than you, you may be able to split your income with them by paying them reasonable salaries or dividends for the work they do for your corporation.
This way, you can reduce your personal income tax and shift some of the income to your family members who will pay less tax. However, you must comply with the tax rules and avoid the attribution rules and the tax on split income (TOSI) that may apply to certain types of income paid to your spouse or minor children.
This used to be a lot easier to execute before the TOSI rules were changed, but it is still possible and useful in certain circumstances.
Maximize your deductions and credits:
You can reduce your corporate income tax by claiming all the deductions and credits that you are entitled to, such as the capital cost allowance (CCA) for depreciable assets, the scientific research and experimental development (SR&ED) tax credit for eligible research and development activities, the apprenticeship job creation tax credit for hiring eligible apprentices, and the Canada employment credit for hiring eligible employees.
There’s a ton of opportunity if you know where to look – and typically a good accountant or business lawyer will point you towards these opportunities.
Strategically plan the timing of your transactions:
You can optimize your taxes by timing your income and expenses strategically.
For example, you may want to defer your income to the next year if you expect to be in a lower tax bracket or have more deductions or credits available.
Conversely, you may want to accelerate your expenses to the current year if you expect to be in a higher tax bracket or have less deductions or credits available.
This way, you can smooth out your income and tax liability over time instead of lumping it all together in one tax year.
Strategic timing is also really popular when it comes to buying and selling assets and entire business.
When you’re buying a business, sometimes you want to plan the acquisition or sale strategically as well to align with other income/expenses in your tax year.
This is all part of the strategic planning that goes into these types of transactions!
P.S. Whenever you’re ready… here are 3 ways we can help you grow YOUR business:
- Find the next greatest strategy, tip or trick to get your business to the next level at The Hansra Law Blog. Each week, we drop cutting edge information and strategies relating to business success, leadership, profit generation and, of course, legal liability.
- Join other like-minded small business owners in our Business Strategy Group! Allow us to be a place to share ideas, get advice and meet others who value growth and profit!
- Work with me PRIVATELY to tackle that pesky business or legal problem once and for all. Email me at Sukhi@Hansralaw.ca with “PRIVATE” in the subject line… tell us a little about your business and what you’d like to work on together, and we’ll get you all the details on fixing your problems!