It all started about a year ago. Actually, probably longer ago than that, most likely. I’m not good at using calendars. I still think it’s 1952.
In an effort to save taxes, I started looking into the benefits of incorporating my small business. I liked the ability to retain earnings in the corporation, as well as not having to pay any CPP contributions.
At that point, I abandoned the idea, since all of my business revenue was coming from one source and the government tends to frown upon such a thing. I decided I’d rather be safe than sorry. The last thing I want to do is piss the government off. Those jerks know where I live, but they’ll never get my phone number. That’s why I change phones every week, like a drug dealer.
These days, things are different. I’ve successfully diversified to the point where only most of my revenue comes from one client, picking up a few additional jobs along my travels. So I went ahead and folded my writing into a corporation.
The rationale for doing so was simple. I wanted to save taxes. But was I really doing so, or am I just fooling myself?
Let’s take a closer look, using a corporation in Alberta as an example.
We’re going to assume somebody makes $100,000 per year in revenue with $10,000 per year in expenses as both a sole proprietor and as an incorporated professional. We’ll assume zero in GST paid or anything like that because no matter how you structure your company the government still gets their share of that.
(Shakes fist aggressively) That’ll show them.
First, let’s look at the tax situation of a sole proprietor in Alberta.
CPP Contributions: ($5088.60)
Operating income: $84,911.40
Tax paid: ($19,841)
Net income: $65,070.40
And now the same person after they incorporate.
CPP Contributions: nil
Operating income: $90,000
Corporate tax (AB): ($2,700)
Corporate tax (Can): ($9,450)
Total tax paid: ($12,150)
Net income: $77,850
HUZZAH! PLAY ME A NICE SONG, GLORIUS TRUMPETS. I HAVE SAVED YOU ALMOST $13,000 PER YEAR.
Stop it. I’m celebrating.
What if they wanted to take that cash out of the corporation?
Really? Do you have to rain on my parade?
I’m just saying it’s an important detail.
AND I’M JUST SAYING YOU’RE A BIG FAT TURD.
Italicized me is right, of course. Here’s how the tax situation differs when you take that cash from the corporation and put it in your back pocket.
You have one of two ways of doing this. You can do it as a salary, which is subject to normal tax rates or you can do it via dividends.
There are pros and cons to doing it both ways. The big pro to taking the cash out as salary is you get RRSP contribution room to go along with it. Utilizing that room minimizes tax in the short-term. Meanwhile, the dividend method results in a metric assload of reduced taxes.
Here are the two tax situations.
Net corporate earnings: $77,850
Personal taxes: ($17,688)
CPP contributions: ($5088.60)*
Net personal earnings: $55,073.40
*Some of this would be a taxable expense to the corporation, but like hell I’m going to try to figure it out. My brain already hurts.
As you’ll see, it costs a lot to give yourself the ability to make RRSP contributions.
Net corporate earnings: $77,850
Non-eligible dividend taxes: ($9,346)
Net personal earnings: $68,504
So, to sum it all up, if you incorporate your business and then take the earnings out as dividends, you’ll put an extra $3,500 in your pocket each year compared to just running as a sole proprietor, at least according to my very specific scenario.
Remember, though, running a corporation comes with extra expenses compared to running a sole proprietorship. You have annual expenses to maintain a corporation. And accountants tend to charge more to do corporate taxes compared to personal returns.
So, in short, you’ll put some extra money in your pocket if you incorporate, but it’s also easy to justify not bothering.
How to put even more in your pocket
The nice thing about a corporation is you don’t have to take the money out immediately. You can leave it in there. This move alone can really help to maximize your income over the long term.
Say we use our example above. Instead of taking all $77,850 out of the corporation, say our employee only takes $44,000 out in dividends. This would lower his total tax bill from $9,346 to just $2,632.
Here’s how it would look:
Net corporate earnings: $77,800
Dividend taxes: ($2,632)
Subtotal: $32,500 (left in corporation)
Subtotal: $41,368 (after dividend taxes)
Total: $73,868 (total of the two)
There are a few problems with this scenario, of course. The first one is perhaps this person needs the full $77,800 to live. It doesn’t factor in any other tax considerations either. And why bother making $100,000 per year if you’re only going to take $44,000 out of the corporation?
Perhaps most importantly, you’re going to create a surplus of funds inside the corporation that could build up for years. This isn’t such a bad thing if you’re running a business that requires capital for growth. But what about a guy like me who’s limited to, basically, exchanging time for money?
I’m forced to invest that capital inside the corporation, which comes with much higher tax rates. Alberta charges a 12% corporate tax on investments while the federal government really wants to discourage investing inside of a corporation with a tax rate of 38.7%.
This is where things start to get too complicated for my layman’s knowledge of taxes. There are certain tax credits that apply to corporations getting investment income in each province. The fine folks at CIBC did attempt to tackle this question in this report I found while Googling.
Allow me to screenshot the results below after this little explanation. If a number is (in brackets) that means it’s a disadvantage to investing inside of a corporation. If the number is normal, it’s an advantage.
So basically, as someone who’s from Alberta, it looks like any advantage I get from corporate versus personal taxes will probably get eaten away over time by these investment disadvantages.
What about Ontario?
Many of you live in Ontario. Allow me to see just how much of an advantage you’ll enjoy incorporation versus going the sole proprietor route.
Sole proprietor taxes:
Operating Income: $84,911.40
Operating Income: $90,000
Ontario corporate tax (4.5%): ($4,050)
Canada corporate tax: (10.5%) ($9,450)
Dividend taxes: ($7,452)
Corporate taxes (if withdrawing $44,000 in dividends)
Dividend taxes: ($1,221)
Total: $32,500 (left in corporation)
Total: $42,779 (dividend income after tax)
Total: $75,279 (total of the two)
Because Ontario has much lower tax rates on dividends than Alberta, taking out $44,000 per year in Ontario works better than it does in Alberta. And since Ontario’s corporate tax rules are more friendly towards investment income than Alberta’s, that advantage continues. This means it makes far more sense to keep as much cash as possible in your corporation if CIBC is to be believed and makes the decision to incorporate in Ontario a much easier one than Alberta.
This presents an interesting conundrum for me, personally. Do I take my corporate earnings and take them out of my company, or do I keep them in knowing I have a tax disadvantage in doing so? Sure, I can put about $5,000 per year in my pocket by only taking some of my earnings via dividends. But I’m also losing out on opportunity costs if I just let that money sit there.
Let’s wrap it up
So, to summarize:
- It likely does make sense to incorporate, especially with CPP premiums going up. Remember, self-employed folks have to pay both halves of CPP contributions.
- It makes sense to only take a portion of your earnings as dividends if possible.
- It may make sense to invest in the corporation over investing personally, although this does not seem to be the case in Alberta. In this case, you’d take only the bare minimum out of the corporation.
- If you live in Ontario, it sure looks like incorporating is the ticket. You can put $10,000 per year in your pocket by being smart with dividend withdrawals. And it looks like it’s better to invest inside of a corporation in Ontario too.
However, before you do any of this, talk to a tax expert. I think I have the gist of this down, but I’m only one man with fair to poor Googling skillz.
Thanks to the helpful tax calculators at taxtips.ca for making this a whole lot easier for me.