Benefit of Incorporation: TAX DEFERRAL

Contact Neufeld Legal PC for your incorporation legal work at 403-400-4092 or Chris@NeufeldLegal.com

Tax deferral is one of the most significant advantages of incorporating a business, enabling a corporation to delay the payment of personal income tax on its earnings, which can provide a number of benefits to the corporate shareholders. The legal concept is based on the two-tiered tax system in Canada:

• Corporate Tax: The corporation first pays tax on its income at the corporate tax rate.

• Personal Tax: The individual shareholder then pays personal income tax on any income they receive from the corporation (e.g., as salary or dividends).

The key to tax deferral is the difference between the corporate tax rate and the personal marginal tax rate of the business owner.

• Low Corporate Tax Rates: In Canada, the corporate tax rates, especially the small business rate for Canadian-controlled private corporations (CCPCs), are significantly lower than the top personal tax rates.

• The Deferral: By leaving a portion of the company's after-tax profits in the corporation instead of paying them out to the owner as a salary or dividend, the owner effectively "defers" the higher personal tax liability until a later date. The money remains within the corporation, where it is taxed at the lower corporate rate.

The Benefits of Tax Deferral: This strategy offers several key advantages for Canadian business owners:

• Increased Cash Flow for Reinvestment: The most important benefit is that it allows the business to retain more of its earnings. This extra cash can be used to fund operations, expand the business, invest in new equipment, or pay down debt. This is a powerful engine for business growth, especially for startups and small businesses.

• Wealth Accumulation: The deferred taxes are not just sitting idle; they can be invested within the corporation. The funds grow on a tax-deferred basis, meaning the investment income also benefits from the lower corporate tax rates initially. Over time, the compounding effect on this larger principal can significantly increase the owner's net worth.

• Financial Flexibility and Control: A business owner can choose when to pay themselves from the corporation. This allows them to manage their personal income and minimize their tax burden in any given year. For example, they can draw a salary or dividend in a year when their personal income is lower (e.g., during retirement or a sabbatical) to avoid being pushed into a higher tax bracket.

Important Considerations and Limitations: While tax deferral is a valuable strategy, there are important rules and limitations to be aware of:

• Corporate-Personal Tax Integration: The Canadian tax system is designed on the principle of "integration," which aims to ensure that over the long term, the total tax paid on a dollar of income earned through a corporation and then paid out to a shareholder is roughly the same as if that income had been earned personally. This is achieved through mechanisms like the Dividend Tax Credit and the Refundable Tax on investment income.

• Passive Investment Income Rules: The government has introduced rules to limit the tax deferral advantage for corporations with a high level of passive investment income (e.g., income from stocks, bonds, or real estate). If a CCPC and its associated corporations earn more than $50,000 of passive investment income in a year, their small business limit (the amount of income taxed at the low small business rate) is reduced. The limit is fully eliminated once passive income reaches $150,000.

• Capital Dividend Account (CDA): One exception to the tax integration principle is the CDA. A corporation can pay out a portion of its capital gains (the non-taxable part) as a tax-free dividend to shareholders. This is one of the few ways to extract tax-free money from a corporation.

• Salary vs. Dividends: A business owner must also strategically decide how to be compensated. A salary is a tax-deductible expense for the corporation but is subject to personal tax and payroll taxes (CPP/QPP and EI). Dividends are paid from after-tax corporate income but can be more tax-efficient for the individual in some situations. The optimal mix depends on the owner's personal financial situation and provincial tax rates.

In essence, tax deferral is not a way to avoid taxes permanently, but rather a powerful way to manage the timing of tax payments. It provides a significant cash flow and investment advantage that can be instrumental in building a successful business and accumulating personal wealth over the long term.

For businesses seeking the potential benefits associated with incorporation, which can be financially significant if properly integrated into one's commercial enterprise, contact our law firm to engage the professional services of an experienced incorporation lawyer. Contact our law firm to schedule a confidential consultation at 403-400-4092 or via email at Chris@NeufeldLegal.com.

* Please note that the flat rates associated with a standard incorporation are strictly limited to a basic incorporation (provincial or federal) and does not involve other matters that might be corrollary to the incorporation process or might be atypical for a standard incorporation, including but not limited to related legal or tax advice, engagement with other governmental bodies or professional bodies, licensing, drafting of pertinent business contracts (i.e., shareholders' agreements), negotiations, disputes, financing, coordination with other companies or other legal structuring.

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