There are many decisions involved in determining whether you should provide services individually (i.e. through a sole proprietorship) or through a corporation. With progressive tax rates in Ontario for individuals reaching as high as 46% while corporate tax rates on active business income dropping to 16%, now may be a time to consider routing your service income through a corporation. This applies not only to regular type services but also to professionals such as doctors, dentists, and accountants who are now entitled to incorporate in Ontario.
Generally speaking, a private corporation that earns professional services income is entitled to claim a tax deduction known as a small business deduction that effectively lowers its combined Federal and Ontario tax rate for 2009 to 16.5% on the first $500,000 of income earned. A second level tax is attributable to any dividends paid from such a corporation to the shareholder. The top marginal tax rate on such dividends for an Ontario resident is 31%. When combined with the small tax rate of 16.5%, this results in a total tax liability on income earned by a private corporation that is distributed to a shareholder at almost 48%, compared to the 46% tax rate earned on income received by an individual directly.
At first blush it does not appear that there is any benefit to using a corporate vehicle to earn your professional services income. However, the key tax benefit of corporate income is the fact that the initial tax rate is only 16.5%, and the secondary tax rate of 31% is only attributable on dividends when paid from the corporation to the individual shareholder. This allows for substantial opportunity to defer tax on income earned in situations in which the individual does not require all the income for personal use.
The first step in determining whether you should incorporate is to ensure that under your professional guidelines you are entitled to incorporate. As indicated above, most professions are now allowed to incorporate in Ontario and this is likely not a roadblock. The next step is to determine whether you will be able to leave profit in the company so as to gain the benefit of the deferral on the lower tax rate on small business income. The question often is one of not whether you can leave money in the company but how much and at what point it is beneficial to consider incorporating. In other words, how much money being left in the company justifies the cost of incorporating and the additional costs of having a separate corporate taxpayer. This is not an exact science and every advisor will give you a different figure as to how much savings makes it worthwhile to use a corporate vehicle to earn your services income. For every $100,000 that you can leave in the company, you are deferring approximately $31,000 in tax. This amount outweighs the cost of incorporation and the annual cost of administration of a corporate entity. Often, even at lower figures, the benefits can be clearly defined and the decision to incorporate can be made.
Several other factors have to be considered when incorporating your business. For example, there are certain rules in the Income Tax Act (the “Act”) designed to prevent the use of the lower tax rate on small business income for employees rather than independent consultants. The personal service business rules contained in the Income Tax Act are designed to prevent an employee of a company from incorporating and receiving business income rather than employment income. A second restriction on the use of a corporation to earn income is where the income is considered investment income rather than active income. Investment income would typically include interest and dividends but might also include rental real estate income. Therefore, when making the decision whether or not to incorporate, a review of the personal service business rules and the investment business restrictions should be completed before making a final decision to incorporate.
A second issue in incorporating is the effect that incorporation may have on the person that you are billing. Often, companies who hire independent contractors would prefer the independent contractors to be incorporated in order to avoid any issues related to the employment insurance legislation, which may deem an independent contractor to be an employee notwithstanding the understanding of the relationship between the parties. The incorporation of an independent contractor may assist the parties by ensuring that employment insurance issues do not arise. Note however, that if you are providing services through a corporation, you will not be entitled to employment insurance protection in the event that your contract is terminated.
Another issue that needs to be reviewed is whether you can incorporate when you are a member of a partnership. The Income Tax Act contains a series of rules to ensure that corporate partners are required to share the low business tax rate available on the first $500,000 of eligible income. These rules effectively prevent corporate partners who operate a business through a partnership from each claiming a separate small business deduction on their respective share of partnership income. Therefore, in a situation when there are multiple partners, all of whom wish to incorporate, the benefits of incorporation might be reduced when the small business tax limit must be shared. Careful planning is required in these circumstances.
With declining rates on corporate small business income, and increasing capacity to earn income through a corporation for professionals, interest in using corporations to provide services is increasing and should be reviewed by all individuals who have the ability to retain their income in a corporation and benefit from the tax deferral. Proper planning and research is required before making the leap into the corporate world to ensure that you maximize all the benefits available.
Gregory Sanders is Head of the Tax Law Group at Perley-Robertson, Hill and McDougall LLP/s.r.l. He may be reached at 613.566.2846 or at firstname.lastname@example.org.
This article was orginally published in a November 2009 edition of the Ottawa Business Journal.