Nevcon Accounting Services - Financial Articles - The Advantages of Incorporation

Click here to go to the Nevcon Accounting Services home page.

Article

The Advantages of Incorporation

Return to Financial Articles index.

There are many reasons to incorporate your business, for both tax and non-tax reasons.

Tax Advantages

Two potential tax benefits of incorporation for a small active Canadian business are:

A tax deferral is possible by retaining earnings in the corporation.
The $500,000 capital gains exemption available for the sale for a small business can only be claimed on the sale of shares of a qualifying corporation and not for the sale of a sole proprietorship or a partnership.

Tax Deferral

Net income of a sole proprietorship or a partnership is taxed directly in the hands of the owner. However, a corporation is a separate taxpayer with its own tax rates.

A Canadian corporation controlled by private corporations or individuals that are Canadian residents will normally qualify as a “Canadian controlled private corporation”. This allows it to claim the small business deduction, a reduction of the normal corporate income tax rate on the first $200,000 of the corporation’s annual taxable income earned carrying on an active business in Canada.

The advantage that the shareholders of this corporation enjoy is the ability to defer the payment of some income tax. A corporation eligible for the small business deduction pays tax at about 25% on its first $200,000 of taxable income. The remaining tax, which is paid by the shareholders upon receipt of dividends from the corporation, is deferred until dividends are paid. When dividends are paid the balance of the tax is levied on the Shareholder.

The deferral can be significant, especially for a taxpayer in the top marginal tax bracket, and means that approximately twice the funds are available for investment, since in effect tax money is being retained in the corporation and invested.

Investment Income

Under the Canadian tax system, the taxation of investment income for a corporation is effectively the same as an individual. Therefore there is no material tax deferral possible on passive income.

Capital Gains Exemption

The other main advantage to incorporation of a small business is the ability to claim the $500,000 capital gains exemption on a sale of the business. The rules are complex, in effect, to claim the exemption – the shares must be of a Canadian controlled private corporation, at least 90% of the assets are used in an active business carried on in Canada, or a holding company which owns such shares.

If the shares qualify, the owner can sell them and the first $500,000 of capital gains are exempt from tax. This exemption applies to the individual and not the corporation. Once this exemption has been claimed it is no longer available on a sale of other qualifying shares.

Source reference: The Tax Page

Return to Financial Articles index.