Last time, we talked about the tax treatment of a business sale, depending on whether the parties are employees or self-employed. This article will discuss incorporation and how it affects a sale transaction.
Tax impact of incorporation
A corporation is an artificial person, so it’s a separate taxpayer from the shareholders that own it. This means a corporation has specific tax characteristics, some of which can provide benefits not available to unincorporated taxpayers.
- Tax rate on business income. Income received by an employed or self-employed person is taxed at his or her marginal rate. Depending on the province, that can range from the teens to more than 50% at top brackets. Comparatively, a Canadian-Controlled Private Corporation (CCPC) is entitled to make use of the small business tax rate, which ranges from about 11% to 19%, depending on the province. The small business rate applies to the first $500,000 of income for both federal and provincial purposes (though Manitoba uses $425,000 and Nova Scotia $350,000).
- Integrated with personal. A corporation is an intermediary before distribution of income to the shareholder. The corporation takes a full deduction for wages paid to an employee, such that the employee pays the all associated income taxes. For amounts the corporation’s been taxed on, it pays out a dividend on which the shareholder tax is reduced to account for previously paid corporate taxes.
- Reinvested earnings. If the shareholder does not need all corporate earnings for current personal needs, the excess can be invested within the corporation. This allows tax deferral at the personal level that will eventually apply on dividends. Bear in mind that complex rules apply to passive/investment income in a corporation, requiring careful management with the benefit of professional tax advice.
- Retirement and health savings options. With the legal separation of corporation and employee (even if the shareholder is the employee), it becomes possible to use RRSPs or even an individual pension plan (IPP). An IPP is able to house even larger deposits than are allowed under RRSPs. Beyond registered savings, there is also the possibility of using a retirement compensation agreement (RCA). Corporations also open up more options for providing health care benefits.
- Income splitting. It is possible to employ others, such as a spouse and family members, whether someone is self-employed or operating with a corporation. In either case, the amounts paid must be commensurate with services provided. Beyond that, the corporation also enables ownership sharing; though, for corporations governed by a professional body, the participation of non-professionals may be limited. Assuming others can be shareholders, dividends may be paid to them, which is particularly beneficial if they are in lower tax brackets.
- Tax on disposition. A corporation can sell its client list, or the shareholder could choose to sell shares of the corporation. If the shares are sold, the shareholder will be subject to capital gains tax, with the potential to make use of the lifetime capital gains exemption.
While tax is often the driving force behind incorporation, there are many non-tax reasons for using a corporation.
- Creditor protection. As a separate legal entity, the corporation is liable for
its actions, but the liability of shareholders is generally limited to losing what they have invested in the corporation. On the other hand, if a creditor requires a shareholder to guarantee the corporation’s debts, then exposure to that creditor is no longer limited. Absent such guarantees, creditors will only be able to look to the corporation’s assets to satisfy their claims.
- Ongoing professional liability. While creditor protection is available to professional corporations in general business dealings, there is no shield against malpractice claims. The professional remains personally responsible for professional services and advice given, for which appropriate liability insurance is required.
- Continuity. As a separate legal entity, a corporation can survive past the departure or death of its shareholders. Where the business is distinct from those who operate it, this can support its independent value and facilitate its transfer.
- Professional image. A business operating through a corporation may be seen as a more stable and durable operation.
- Broadened and shared ownership options. It can be helpful to formally isolate business interests in a corporation from personal interests. As things grow, an additional corporate layer may be desired to separate operating assets from surplus assets held through a holding corporation. Where multiple business principals are involved, it may be necessary to create two or more lines of holding companies. And, as family are involved, trusts may be used to house and protect their interests, and to guard against their over-involvement in the business while preserving intended tax benefits.
Meeting your client expectations? Half of investors are prepared to switch firms
Clients expect their advisors to stay on top of technological, economic and demographic shifts that will transform the wealth management industry by 2021, finds research by Roubini ThoughtLab.
Investors expect new advisory and digital solutions that some advisors aren’t prepared to offer, and if client needs aren’t met, 48% of investors say they’ll switch providers.
The research is based on a survey of 2,000 investors and 500 investment providers across 10 major wealth markets, as well as in-depth interviews and economic modeling. The study, released in September, was produced in conjunction with BMO, Broadridge Financial Solutions, CFA Institute, Cisco, eToro, Schroders, SEI and State Street.
In the next five years, investors worldwide say they will expect more from advisory firms, including more customized solutions (72%), access to wider investment options (64%), greater cybersecurity (63%) and the use of the latest technology (62%). Many of them will also demand more from personal wealth advisors: responsive 24/7 service (51%), advice that delivers high returns (40%), digital proficiency (37%), broader financial and life-planning advice (36%) and lower fees (35%).
While wealth providers are attempting to adapt, some are not as prepared as clients think. For example, 63% of investors believe their providers are prepared to ensure cybersecurity, versus 48% of providers who say they are. Similarly, 64% of investors say their investment providers can offer options across asset classes and global markets, while 47% of firms say they are prepared to do so.
The research also indicates more technological disruption. For 59% of investment providers, a top priority is to build, partner or acquire fintech capabilities, and most wealth firms say they are developing new digital capabilities, such as “anytime, anywhere, any device” access.
Part 5 (this article): Incorporation issues when selling your book