This article is written by the Chartered Professional Accounting firm of Edelkoort | Smethurst | Schein as our way of explaining in simplistic terms, the tax implications of operating sole proprietorships, partnerships, and corporations in Canada. Starting with setting up shop as a sole proprietor, and then progressing to establishing a corporation. In between, you might join with others to form a partnership.
And by the way, yes, our firm does indeed provide the services required to prepare all of the income tax returns and other filings for any type of business. Please read on – we are sure it will all make sense. Also, we are a public accounting firm located in Burlington, Ontario, Canada, and this article is based on regulations in our jurisdiction, which may not be applicable to your situation if you are a reader outside of Canada.
Preface – the limited liability afforded to CCPC, and lower tax rates more than offset the extra fees for setting up the CCPC, and annual tax filings. However, these savings only come to fruition if the CCPC has relatively high income, and the owners do not need to withdraw all of the earnings each year.
Most businesses start as single owners. An idea for a business germinates, they toy with the idea, tinker with the concept, discuss the plan with their accountant and other advisors (strongly recommended), and if the plan seems sound and viable, the business is launched. Operating the business as a sole proprietor from the get go often makes a lot of good sense. Below are some bullet-points that pertain to all sorts of tax and operating concepts to take into consideration with regard to sole proprietorships.
- Business name – should be registered with the appropriate government office to protect tradename.
- Make sure to track your revenues and expenses – set up an Excel spreadsheet, use accounting software, or engage services of bookkeeper or an accountant – you will need this for sales tax and income tax reporting.
- Revenue and expenses are reported and included as part the individual income tax return – Schedule T2125 – Statement of Business or Professional Activities contains the details, which in turn is summarized on the Form T1 – as Self-employed income. This is included with all other types of income, and taxed accordingly at the taxpayer’s marginal tax rate. The amount of money drawn out of the business and paid the owner is irrelevant for tax purposes – tax is paid on the net income of the business as part of the individual tax return.
- HST – the business would need to register for the Harmonized Sales Tax (HST), if annual sales of the business exceed $30,000. If so, the implications are as follows;
- The business needs to charge customers 13% HST, if the customer is in Ontario. Other rates apply depending on where your customers live.
- Exports of goods and services outside Canada – HST is nil (But you still need to track this).
- Quarterly instalments, and annual filing are required.
- From the HST collected from sales, the business deducts the amount of HST it pays to suppliers. This is known as an Input Tax Credit (ITC).
- The net amount is remitted quarterly to the Canada Revenue Agency (CRA).
- The ‘Quick Method’ of reporting HST could save taxes, the business can set this up when the business it is launched or after the fact.– please discuss with your accountant as it only applies to small businesses.
- An annual HST return must be filed by June 15th of the following year.
- Expenses – the overarching concept for tax purposes is that the expense must be for business purposes (not personal) to generate profits, and must be reasonable. A few noteworthy items;
- Make sure you have a system in place to track the expenses, and keep copies for audit purposes. Electronic copies are acceptable and there are several smartphone apps available which will allow for a photo to be stored and uploaded for accounting purposes.
- Home office:
- Depending on the type of business (commissioned sales persons), there are several home office expenses that are deductible for tax purposes including; utilities, insurance, maintenance, property tax, and others that relate to operating your business.
- Deductible expenses are restricted to the proportion of space the home office occupies in comparison to the total square footage of the home, so you need to do the math and come up with the personal % and business %.
- Business owners cannot have a Home office and a separate external office – must be one or the other.
- Meals and Entertainment – only 50% of the total dollar amount is deductible for tax purposes. The 50% difference is taken into account when completing Schedule 2125 on your personal income tax return.
- If the vehicle is owned, the fair market value of the vehicle should be ascertained at time the business commences which then becomes the cost figures used for tax purposes. The cost of the vehicle (to a maximum of $30,000 + HST) can be amortized over a period of years. This is a deductible expense for tax purposes (known as capital cost allowance or CCA).
- If the vehicle is leased the payments, subject to limitations, can be deducted as an expense.
- Fuel, maintenance, insurance are deductible.
- The total amount of automobile expenses deductibl, is restricted to business use of the vehicle – you need to keep track of total kilometers and business kilometers. Lots of smartphone apps available for tracking, or good ole fashion manual logs.
- Other – any expense that is incurred to generate profits and is reasonable is deductible – keep track of your expenses.
- Personal clothing, groceries for personal consumption and other personal use items are not allowable business deductions.
- Salaries, wages, and benefits – operating a sole proprietorship does not mean staff cannot be hired. Employees can be hired, and the salary or wages are a deductible expense – just remember, in doing so, a Payroll tax account has to be established with the Canada Revenue Agency with quarterly or monthly remittances and preparation of annual tax slips (T4).
- As mentioned, the net income is included as Self-employed income on your individual income tax return (T1), added to your other types of income and taxed at whatever your overall tax rate happens to be. Keep in mind that in Canada (and U.S.A.), individual tax rates gradually increase as income increases. For 2016, the Canadian federal tax bracket starts at 15% for income and increases to 33% for income over $200,000. Add to this provincial taxes (which are also graduated), and the highest combined bracket in Canada is in the 45% range.
- Sole proprietorships must also contribute to the Canada Pension Plan (CPP) and the required CPP contribution is an additional amount of ‘tax’ that is due. The CCP contribution rate is 9.9% to a maximum of about $5,100 (tax year 2016).
- Quarterly income tax instalments – keep in mind that sole proprietors should plan to remit income tax instalments on a quarterly basis. CRA provides for some options in terms of the dollar amount of the instalments. Most common calculation method is to use the previous tax year’s actual tax liability (including CPP). Just keep in mind that if your quarterly instalments are less than they should have been, CRA will take that into consideration and charge you a penalty and past due interest.
- Legal liability – something to consider as part of your decision – sole proprietorships DO NOT provide protection against lawsuits from other parties. If creditor protection is an issue for your particular business or situation, you should consider incorporation.
- Financial statements – Statement of Financial Position (Balance Sheet) and Statement of Operations (Profit and Loss) should be prepared by the owner in order to accurately track and evaluate the performance of the business. Also, for preparing tax returns, Schedule T2125 – Statement of Business or Professional Activities relies upon the Statement of Operations. HST returns rely upon the Statement of Financial Position. Review with your accountant to determine if ‘Notice to Reader’ financial statements are required –really depends on the complexity of your operation.
Summary – setting up and operating a sole proprietorship is a very challenging undertaking. From a taxation standpoint, as explained above, the income is included in the individual tax return, and taxed at the marginal tax rate. So, if your income levels are at the low end of the spectrum (say 15% federal tax bracket), there is no real tax advantage to incorporating. If income levels get into the range of $100,000+ range, the personal income tax burden increases, and it might be time to consider incorporation to save taxes. Please read on.
The term used for small private corporations is Canadian Controlled Private Corporations (CCPC). Corporate tax rate for CCPCs is in the 15% range for income levels below $500,000. That’s a very low and attractive tax rate, but there are several caveats to consider. The primary one is that the Canadian tax structure is based on the notion of ‘integration’ between the corporation and the individual. What does this mean? Income earned in a corporation and then paid to the CCPC owner(s) in the form of either a salary or dividend, results in combined corporate and individual income tax that would be the same as if the income was earned directly by an employee earning a salary. Best way to understand this is to review an illustration. Please see the example further below, but please read on beforehand.
The second caveat to consider is an extension of the first – if you need to draw out all of the earnings of the corporation to the owners each year, then there really is no tax advantage between a sole practitioner and incorporation. If on the other hand, the owners are able to retain the earnings within the corporation to reinvest them – that is when the greatest tax advantages are realized. Of course, at some point, the owner will need to withdraw some of the funds, and at this point personal taxes are paid. In the meantime, owners can take advantage of tax deferral.
Corporations are separate legal entities from that of the owners. Therefore, the first step in the process is to incorporate your business. We highly recommend that you use the services of a legal firm in conjunction with a professional accounting firm – to ensure that the legal structure including shares, classes of shares, rights of share classes and accounting is set up properly. There are also some considerable tax planning considerations. First, if your sole proprietorship has been in existence for some time, and has assets and other items of value, you will want to transfer them from you as an individual to your corporation, without having to pay tax on this individually. This is known as a ‘Section 85 rollover’ and can result in tax-free dollars paid back to the shareholder. If this is not done, the individual is basically selling their stake in the business to the new corporation, and this is a taxable capital gain for the individual. Section 85 rollover basically allows you to transfer the assets from an individual to a corporation without any immediate tax consequences. Second, the share structure should be examined. Will all of the shares be common shares, or will some of the shares be preferred shares? Will all of the shares be owned one individual or will some portion of the shares be owned by other family members who are active in the business? It’s important to consider the future sharing of the profits of the corporation when paying dividends, and selling the shares in the future. All very important reasons why it is necessary to discuss and review the incorporation with legal and accounting professionals. Keep a separate file with articles of incorporation, minute book and other documents related to the foundation of the company.
Canadian corporate taxes are fairly complex. The following is a broad overview of tax and operating concepts to take into consideration.
- Separate business number registrations must completed for the corporation. This includes Corporate Tax, HST and Payroll accounts. This is a common error – you cannot continue to use the same business numbers used as a sole proprietor. They must be a new numbers set up specifically for the corporation.
- From an accounting standpoint, the concepts for corporations are very similar to that of sole practitioners outlined above. The tracking of revenues and expenses supporting the preparation of financial statements is basically the same and should be done using appropriate accounting software. Most corporations will hire a bookkeeper to record transactions, and a designated accountant to prepare financial statements and corporate income tax filings. The preparation of ‘Notice to Reader’ financial statements are not a legal requirement in support of corporate income tax filings, but are highly recommended. In fact, CRA specifically asks whether or not the T2 has been prepared by a designated accountant, and if financial statements have been prepared in support of the T2. Best to avoid potential CRA audit of the corporate tax filings and have Notice to Reader compiled financial statements prepared by a designated accountant. Please keep in mind that our firm can assist with bookkeeping, financial statements and corporate tax filings and planning. If you are interested in learning more about Notice to Reader financial statements, please refer to our companion article on this subject.
- Revenues and expenses are reported and included as part the corporate income tax return – Form T2. There are numerous schedules supporting T2 including Schedule S125 which contains the income statement details, and Schedule S100 containing the Balance Sheet details.
- HST – the corporation would need to register for the Harmonized Sales Tax (HST) if sales are greater than $30,000 annually, which usually is the case for a corporation.
Canadian corporate tax rates
Federal corporate tax rate
- Corporate income tax rates for Canadian controlled private corporations (CCPCs) are very low, which is one of the primary reasons for establishing a corporation, the other being to provide limited liability. Let’s discuss why this is case right now, at a fairly high level to promote understanding.
- The corporate tax rate for all Canadian corporations, including CCPCs, starts with a basic federal tax rate of 38%. This is also known as Part 1 tax. Subtract from this 38% several deductions:
- Federal tax abatement of 10%. This deduction from federal taxes allows each Canadian province to subsequently add their respective provincial tax rates (see below). This deduction is applicable only to Canadian source income, and not foreign source income.
- Small Business Deduction(SBD) 17.5%. This deduction is on first the $500,000 of net active business income. A few concepts should be pointed out. First, the income must be from an ‘active’ business income (ABI), and not ‘passive’ such as investment income or rental property income. Second, the to the first $500,000 of ABI and must be shared between associated companies. This means an owner of several CCPC’s is not entitled to $500,000 for each business – it must be shared, and the total cannot exceed $500,000. It is always a good idea to have your accountant review your corporate structure to assess existing relationships or relationships you didn’t realize existed, the last thing you want is for the CRA to claw back the small business deduction. Finally, the SBD rate of 17.5% is applicable for 2016, this rate is revised periodically by CRA.
CCPCs with ABI of less than $500,000 have a federal corporate tax rate of 10.5% in 2016.
Provincial corporate tax rate
- Provincial corporate income tax rates vary by province – Ontario assesses a basic rate of 11.5% but also offers a small business deduction (OSBD) of 7% therefore in Ontario you can expect to pay 4.5% tax on the first $500,000
As a result, Ontario CCPCs with ABI of less than $500,000 have a combined federal and provincial corporate tax rate of about 15% in 2016. Pretty attractive rate, and as mentioned previously, would pertain to situations where the owner retains the profits in the business, and not draw out significant salary or dividends.
Salary and Dividends
As mentioned, whenever an owner draws out funds out of the CCPC for personal use, these funds will need to be included in the owner’s individual income tax return. The income can be reported as either salary or dividends. The split between the two is based on the lowest overall combined corporate and individual income tax. This analysis is normally prepared by your accountant at the end of the year, and reviewed with you for your approval. Salary and dividends each have unique tax implications that need to be considered for each situation.
Salaries are deductible as a corporate expense, but attract payroll taxes such as the employer portion of CPP. Salaries are fully taxable in the individual’s income, and include deductions for the ‘employee’ portion of CPP. Furthermore, whenever salary is paid, this requires filing on annual T4 slip with CRA, no later than the end of February of the following year. If the corporation has not paid made Payroll remittances during the year, of course CRA will charge a penalty and past due interest. Individuals drawing a salary could be eligible to deduct certain expenses paid personally for the business against his/her salary. This is especially an important consideration when determining whether to have the business own/lease an automobile or for the individual to do so.
Dividends are not deductible as an expense. Instead they are paid to the owner with ‘after-tax earnings’. So, this means corporate taxable income will be higher as compared to salary situation, resulting in higher corporate income taxes. However, dividends are taxed at a much lower rate in the owner’s individual income tax return. This favourable tax treatment for the owner is in recognition of the higher taxes paid by the corporation. Dividends paid to the owner must also be reported to CRA using a tax slip known as a T5, which is also due no later than the end of February of the following year.
The reduced tax rate on dividends paid by a CCPC is accomplished by way of a 2 part calculation. The first part is 18% ‘gross up’ of the dividend payment increasing taxable income for the owner. This is offset by the 2nd part known as the dividend tax credit which reduces taxes by about 17.4% of the dividend paid. The result of this calculation is to once again, ensure proper integration.
Also, the terminology non-eligible dividend should be explained. Non-eligible dividends are dividends paid by a CCPC from income that benefited from the small business deduction. The CCPC benefited from a low corporate tax rate as a result of the SBD, and therefore the tax authorities do not allow the enhanced dividend tax credit offered on other types of dividends paid from earnings not benefiting from the SBD. Hence the term non-eligible dividends to denote CCPC dividends paid from these earnings.
Dividend account balances – CDA, eligible/regular, ineligible and RDTOH
While we are on the topic of dividends, it should be noted that the Canadian corporate tax system has four different types of dividend accounts. There are fairly complex rules to determine how each dividend account balance is determined, and the following is a basic overview of the rules and rationale. In short, the balances are based on the different types of earnings which might occur for a CCPC during any particular year. Please read on – hopefully it will make sense, and further your understanding on how accountants can minimize the CCPC owner’s overall corporate and personal income taxes on dividends paid to them.
How do accountants determine the type of dividend should be paid to the owner of a CCPC? This decision of course, is aimed at reducing overall personal and corporate income taxes, but how is it decided? The answer is based on the following analysis:
- Capital Dividend Account (CDA) – in Canada, only 50% of a capital gain is taxable. A capital gain represents the difference between the sales price of an asset less the cost of the asset. The CDA account contains the tax free portion of capital gains earned. Any dividends paid from CDA to the owner, are completely tax free to owner as an individual. This is the ideal situation.
- Dividends paid from earnings that are not subject to the small business deduction ($500k) are known as ‘eligible dividends’ (aka regular dividends) and attract personal income tax for the owner at a lower rate. Why? Because the SBD was not available on these earnings, and corporate income taxes were higher, and therefore personal income tax rate is lower to allow for better ‘integration’.
- Dividends paid from earnings that are below the small business deduction ($500k) are known as ‘ineligible dividends’ and attract personal income tax for the owner at a higher rate. Why? Because the SBD was available on these earnings, and corporate income taxes were lower, and therefore personal income tax rate is higher to allow for better ‘integration’.
- Refundable Dividend Tax On Hand (RDTOH) – this account is a ‘holding account’ for tax paid on investment and dividend income earned by a CCPC. These incomes attracts additional taxes to be paid by the CCPC. The additional taxes are temporary until such time as a dividend is paid to the owner, at which time the tax is refunded by CRA to the CCPC.
- Your accountants should be reviewing the CDA, eligible/regular, ineligible and RDTOH dividend account balances for the CCPC, and make a decision which minimizes overall corporate and personal taxes for the owner. Afterwards, the accountants, acting on behalf of the CCPC would issue the appropriate tax slip (usually T5, but also T2054 for CDA dividends).
Please see the example below. The example illustrates the notion of integration, and demonstrates that in order to understand the true picture and make the correct decision, you need to examine the combined corporate and personal income tax. The owner needs to evaluate the optimum split between salary and dividends. This is very specialized tax expertise, which most owners do not have – this is part of what our firm will provide you as part of the corporate and personal tax planning.
In this example, assume that the corporate earnings are eligible for the small business deduction. Any dividend issued will be a non-eligible dividend, subject to the 18% gross-up and the related dividend tax credits.
Personal services business
A few words of caution about establishing a CCPC if you are essentially performing the services of an employee to a business. In these situations, the CRA will disallow all of the deductions normally offered to a CCPC, including the small business deduction and all other operating expenses. Allowable business expense deductions are restricted to expenses that employees are permitted – which are few and far between – but would include salary, wages and benefits paid to the incorporated employee.
A personal services business is a business that a corporation carries on to provide services to another entity (such as a person, partnership or corporation) that an officer or employee of that entity would usually perform. Instead, an individual performs the services on behalf of the corporation. That individual is called an incorporated employee.
Any income the corporation derives from providing the services is considered income from a personal services business, as long as both of the following conditions are met:
- The incorporated employee who is performing the services, or any person related to him or her, is a specified shareholder of the corporation; and
- The incorporated employee would, if it were not for the existence of the corporation, reasonably be considered an officer or employee of the entity receiving the services.
For more information on the factors to take into account when a person is considered an employee, please contact your accountant to review the details. The factors are based on Canadian case law.
However, if the corporation employs more than five full-time employees throughout the year or provides the services to an associated corporation, the income is not considered to be from a personal services business. In these situations, the income is eligible for the SBD and other operating expenses.
A specified shareholder is a taxpayer who owns, directly or indirectly at any time in the year, at least 10% of the issued shares of any class of capital stock of the corporation or a related corporation.
Personal services business is an area that CRA monitors fairly closely, so if you have any doubts about the structure of your operation, and whether or not any of your income might be considered that of an incorporated employee, it is best to contact our firm to discuss.
Specified investment business
Another form of CCPC that the CRA employs special rules to restrict the deduction of the small business deduction is what is known as a specified investment business.
A specified investment business is a business with the principal purpose of deriving income from property, including interest, dividends, rents, or royalties. It also includes a business carried on by a prescribed labour-sponsored venture capital corporation, the principal purpose of which is to derive income from property.
Except for a prescribed labour-sponsored venture capital corporation, income from a specified investment business is considered to be active business income, and is therefore eligible for the SBD if:
- The corporation employs more than five full-time employees in the business throughout the year; or
- An associated corporation provides managerial, financial, administrative, maintenance, or other similar services to the corporation while carrying on an active business, and the corporation would have had to engage more than five full-time employees to perform these services if the associated corporation were not providing them.
Note – the business a credit union carries on, or the business of leasing property other than real property, is not considered specified investment business.The message here is fairly straightforward – if you own investments or property rentals, the income earned in the corporation will not be entitled to the small business deduction, unless you employ more than 5 full-time employees. If you employ 5 or less employees, the corporation will not be able to deduct the SBD, which from a tax perspective, largely negates any tax savings in comparison to operating as a sole proprietor. However, the concept of limited liability within a corporation remains a consideration.Summary – Incorporation can be a very daunting process and it may or may not be suitable for your situation. We always recommend that you review your business plans carefully with our firm to ensure you are making an informed decision, to understand the process and filings, and to minimize taxes and fees.
And finally, there is another option, and that being the formation of a partnership. There is legal terminology around partnerships that must be reviewed with your legal counsel to ensure that it is established properly and in compliance with laws. There are several different types of partnership structures available which can also limit personal liability to the business of the partnership and furthermore to exclude other partners conduct outside of the business. Once again, please review with legal counsel.
Although a separate legal entity, from a tax perspective partnership income earned is reported on the individual income tax return, in proportion to each owners’ pro-rata share of the business. The rules governing revenues, expenses and financial statements are consistent with sole proprietors and CCPCs, however separate business registrations need to be established for the partnership.
Referring back to the individual income tax return, the details of the partnership operation are reported Schedule T2125 Statement of Business or Professional Activities which in turn is included in T1 as self-employed income. The main difference is that towards the end of Form T2125, the partners report their respective ownership interest, which in turn determines the net income to be included. Key point, once again, is that the net income is included as Self-employed income on your individual income tax return (T1), added to your other types of income and taxed at whatever your overall tax rate happens to be.
Summary – Partnerships offer owners the ability to combine their resources for the betterment of the business, limiting their liability exposure, while at the same time maintaining a fairly straightforward mode of operation. From a tax perspective, proportional net income is included in the T1 individual tax return.
We hope you enjoyed reading this article and were able to glean from it an understanding of the differences between sole proprietorships, corporations and partnerships. The tax concepts can be very complex, and are always changing. Our firm has the experience and expertise to support you throughout the process – give us a call – we would be pleased to hear from you.