The Decision to Incorporate [Part 2]

Advantages of Incorporation

Income Tax Deferral [continued]

In part 1 the point was made that the personal income tax system in Canada is a progressive tax system where the more money you make the more the government takes.  Consider the information provided in the table below.

If your income in 2009 was $50,000 and you had the maximum withholdings for Canada Pension Plan contributions but no deduction for Employment Insurance, you would have to pay $7,980 in income taxes.  If your income was $75,000 you would have to pay $16,022 in income taxes.  If your income was $100,000 you would have to pay $26,356 in income taxes.  Whereas, you pay $7,980 of income taxes on the first $50,000 of income you pay $8,042 [$16,022-$7,980] income tax on the next $25,000 income.  Then on the next $25,000 of income you pay $10,334 [$26,356-$26,022] in income taxes.

As you can see you pay more income taxes on the $25,000 of income  earned after $50,000 then you do on the intial $50,000.  And you pay even more income tax on the next $25,000 — and on it goes.

How to defer income tax using a corporation

Consider the fictional taxpayer Mike Kilpatrick.  For several years, Mr. Kilpatrick operated a business as a sole proprietor.  Each year his profits from the business were $50,000.  He managed his money well, adjusted his lifestyle to his income. Mr. Kilpatrick indicated he was quite content with his level of income. Each year he paid his taxes which in 2009 were $7,980.

Imagine that Mr. Kilpatrick’s business flourished in 2009 and that instead of making his normal profit of $50,000 he earned $100,000 of profit.  Because his business is carried on as an unincorporated business Mr. Kilpatrick must pay income tax on the entire $100,000 of profit.  His income tax bill on that amount would be $26,356.  Mr. Kilpatrick called his accountant thinking there must be some mistake, “How is that when I make $50,000 I paid $7,980 in income taxes but when my profits doubled to $100,000 my income taxes more than tripled?”  His accountant informed him the amounts were correct.  Mr. Kilpatrick asked his accountant if anything could be done to reduce the income tax impact in the future.  “Incorporate your business,” replied his accountant.

The accountant showed Mr. Kilpatrick the chart below to explain the benefits of incorporating.

The accountant knew that Mr. Kilpatrick was content to live on $50,000.  If his business was incorporated Mr. Kilpatrick could pay himself a salary of $50,000 as that was all he needed to live on.  He could leave $50,000 in the corporation.  The company would pay taxes of $8,250 [$50,000 @16.5%] on that amount.  This would result in a total tax of $16,230 – $7,980 on the $50,000 earned by Mr. Kilpatrick and $8,250 on the $50,000 earned by the corporation.  This is $10,126 less than the $26,356 Mr. Kilpatrick would have to pay if he earned that $100,000 personally.

The column titled “Tax Deferred” shows how much tax could be deferred each year if,  instead of Mr. Kilpatrick earning the amounts in the column titled “Income” the corporation earned those amounts and paid tax on the income remaining after Mr. Kilpatrick paid himself a $50,000 salary.  

For example, if the corporation earned $200,000 in profits, before deducting Mr. Kilpatrick’s salary of $50,000, the company would pay income taxes of $24,750 on the remaining $150,000.  The total tax bill of  $32,730, [$7,980 on the $50,000 earned by Mr. Kilpatrick and $24,750 on the $150,000 earned by the corporation] is $39,248 less than the amount of taxes Mr. Kilpatrick would have to pay if he earned that income personally.

Mr. Kilpatrick told his accountant that he had been preparing some forecasts for the business and  that he thought it could make $250,000 in profits in the next year.  He sheepishly noted to his accountant that he wouldn’t mind increasing his salary to $100,000 and then asked if it would still be worth doing this through a corporation.

The accountant prepared the chart below.  On $100,000 salary Mr. Kilpatrick would have to pay $26,356 in income tax and the company would pay $24,750 on the remaining $150,000 for a total tax bill of $ 51,106. This is $44,227 less in taxes than the amount Mr. Kilpatrick would have to pay if he earned that $250,000 personally.

The tax savings remain in the company and could be used to pay down loans, to purchase additional inventory or capital assets that might be needed to grow the business.

When those profits in the company are paid to Mr. Kilpatrick at some future date,whether as salary or dividends  he will have to pay income tax on those amounts.  For that reason we say the tax is deferred not reduced. 

Note that this deferral only occurs when the business earns more in profits than Mr. Kilpatrick, in our example, needs to live on.  If, Mr. Kilpatrick increased his salary to match the profits of the company there would be no deferral benefits from incorporating the business.

While deferring tax is often the main reason given to incorporate a business there are many others.  I will quickly highlight these in part 3.