Your incorporated business is an extension of YOU

As we prepare for a post COVID economy, many Canadians are starting their own business. 

If you’re becoming an entrepreneur, there are many new roads you will travel, one of them is incorporating your business. Tax implications, pension plan and making sure your corporation doesn’t become YOUR boss.

In this terrific episode of SARA MAKES SENSE, Sara peels back the layers on incorporating your business and why incorporating could save you money, sleepless nights and even relationships. 

Got a question for Sara? Send her an email at ask@saramakessense.ca and she might respond to it in an upcoming episode

Sara's website is https://www.wddevelopment.ca/ 

Transcript

Sara McCullough (00:01):

Yeah, I'm completely not ready. So let's do this thing. 

Sara McCullough (00:17):

You started your own business. You've worked through the initial dreaming, planning, late night conversations, planning again, and you did it. You picked a name and you put the letters IMC after it. You incorporated your business. Because, well, it feels official. It feels serious. Because someone told you to. Somebody that you really respect. 

Sara McCullough (00:46):

Maybe you didn't start a business, exactly. Maybe you graduated and started your practice. As a lawyer, a dentist, doctor, optometrist, veterinarian. You can incorporate those practices, even if you don't fully know what that means. The name of your corporation has more restrictions, but you still have a name. And those three letters IMC after it. In 19 years of advising, clients have the same question about their corporations. If you don't have one, but know that you can, you want to know as much as possible about how it works. I've done presentations to med students in their first year about what happens when you incorporate. If you have one, there will be days that you feel like your corporation is the boss of you. Like your corporation is rich and you are not. Like you're working to fund your corporation. What was the point of this? In today's episode of Sara Makes Sense, I'm talking about the what, whys, and hows of corporations. There are so many great reasons to incorporate and all of them should be related to you, your family and your goals. 

Sara McCullough (01:59):

In today's episode, we're mainly focused on owner operated corporations or professional corporations. And so let's talk a little bit about what exactly is that? Your corporation is a separate legal entity from you. And again, when I think about the conversations that I've had with clients over the years, they definitely get the separate part because it really feels separate. And the most common question I get is how do I use this thing? What's it doing for me? So let's talk about a specific example. If I open a business, let's say I open Bob's Big House of Noodles. I can run that as just me. I own Bob's or I can incorporate. If it's just me running Bob's and owning Bob's, I file a single tax return under my name, Sara McCullough. And under the total income section on my tax return, there's a line that says business income, and I enter the total sales of noodles minus the total cost of running the place. 

Sara McCullough (03:07):

And that's taxable income to me. If I incorporate, so now there's, Bob's Big House of Noodles, INC it's going to file its own tax return. It files a corporate tax return that still includes the total noodle sales minus the total costs. But in that case, I could be a cost to Bob's. I could pay myself a salary or I could pay myself dividends and I could leave some profits in the corporate account and pay myself nothing. So that's what it means when things are separate from you, there's going to be two tax returns and you've got more options in there. 

Sara McCullough (03:50):

So once you've got this separate thing, how do you talk about who owns the thing and who can do what with the thing? So corporations have shares and we're familiar with this idea. If you think about any publicly traded company, if you have an investment account or own a mutual fund, you probably own shares of all of the big five Canadian banks. So TD bank issues shares, GM issue shares, all kinds of companies, issue shares. When you have your own corporation, you're also going to issue shares. So Bob's Big House of Noodles can issue shares. I can own all the shares. If it's just me, I'm going to own all of the voting shares. I could share the business with somebody else. Maybe I have a partner in this, in this venture, and we can talk about who owns how many shares. We could both own voting shares. 

Sara McCullough (04:56):

In the past, I've worked with a client who started his own company and he did incorporate it. And about a year later, he took on a partner. And so he changed his corporate structure to give shares to his new partner. At the beginning, it seemed like 50/50 was a good idea. And so he did that. And then about two years later, when they started to disagree, 50/50 felt like an obstacle because they can deadlock each other. So the other important part, when you have a corporation and you have shares, talk to your partner about what you each want. If you go 50/50, and there are good reasons to do that, make sure you have a mechanism and a plan to talk about what happens if you disagree. You kind of need a tie breaker or you kind of need a way to get through different ideas without harming the business and without harming your relationship. 

Sara McCullough (06:11):

So you've got your corporation. You've decided who owns what and who can make decisions on what. And now we still aren't clear on some of the what's. Probably, you incorporated because your accountant told you that you pay less tax. And that's true. The corporate tax rate for active business income is lower than the personal tax rate. So there's a lot of things in there. And again, in this podcast, we're not going to get super duper deep into the details, but it is important that you understand a couple of the things that in that sentence. So the corporate tax rate is less than the personal rate on your active business income. So if we go back to Bob's Big House of Noodles, my active business income there is selling noodles and whatever else is on the menu. If you're a dentist, your active business income is anything you do related to dentistry. If you own a flower shop, your active business income is anything you do related to selling flowers or making money from flowers. 

Sara McCullough (07:38):

There's been a lot of talk in the last couple of years about passive business income. And some clients have said, “is it still worth incorporating, I thought I heard it was awful”. What did increase, is the taxation on what's known as passive business income. I said a few minutes ago that if I incorporated my Big House of Noodles, I could leave profits in the corporation, and they could just stay there so that the corporation has that as an asset. If I invest that money and make money on that money, that's passive business income because it didn't come from selling noodles, which is my active business. So absolutely in the past couple of years, for a variety of reasons, the taxation on passive business income has gone up. There are still reasons to leave money in your corporation, and I will cover those in the related blog post, but just know that it is still worth a conversation about incorporating your business and leaving profits in there. 

Sara McCullough (08:52):

So what kind of difference are we talking about? Well, if I make $400,000 selling my noodles after expenses, if I didn't incorporate the House of Noodles, I would declare that on my personal tax return as taxable income. And my marginal rate of tax on anything over about $220,000, if I live in Ontario, is just around 53%. So on the top half of my income, I am losing about half. If I incorporate, Bob’s Big House of Noodles incorporated is going to hold that $400,000 for me. Maybe it paid me a salary of $120,000 because that's what I needed to live on. And so Bob's Big House of Noodles incorporated is gonna hold that $280,000 for me. And on that amount, the federal tax rate is around 15%. Again, provincial rates weigh in there. It varies from province to province. Again, head over to the blog post, to see a chart for that. 

Sara McCullough (10:17):

But I'm betting you can sense the taxation on that 280 is far, far less inside the corporation than it would be if I declared that 280 personally. So that's where you're getting that tax advantage. It gets you more that stays with you in the year that you earn it. And again, when you have a profitable business, whether you're incorporated or not, you're going to need a plan for how do you use this to meet your goals. Because we're only ever earning money to meet our goals. Money on its own, not always that fascinating. What we want to do you with the money and the choices we make for ourselves and our families and for people who matter to us, that's what's fascinating, that's why we do this. We're gonna do it for either love of the business that we have or love of our goals, or both. 

Sara McCullough (11:28):

As I said earlier, often it becomes confusing on how do you access this money? When you're setting up a corporation, most of my clients’ questions centre around the kind of, how do I move this? Where do I deposit this? How do I get this back to me? And then as you become profitable and you leave some money inside your corporation, probably because your accountant told you to, then it becomes, now it really feels separate. Now it feels like my corporation is the boss of me or my corporation is rich and I'm not. Again, this is where you need some planning to figure out how to use this, to support your goals. As I said, tax efficiency is only fascinating when we figure out what we want to do with that money that we've saved 

Sara McCullough (12:41):

A number of years ago, I was having a meeting with one of my clients. They were in their early forties. He had a professional corporation and they were good savers. And she said to me, in the meeting, “Sara, what happens if we take more money out of our corporation”? And I said, “well, you pay more tax”. And she said a lot more because our accountant looks like he's going to have a heart attack when I ask him about this. And so we talked a little bit about what the numbers would be based on an additional amount and they weren't big, but they were there. 

Sara McCullough (13:30):

And at the end of the conversation about the numbers, she said, “okay, so could we take out money and buy a new couch, because we have the same couch that we had when we were both in university”. Please buy the couch. You are both professionals. You have saved well. At that point, they had a house, they had RSPs, and they had about $800,000 inside their corporation. And she wasn't sure what would happen if they bought a couch. So, you can see how this idea of the separate legal entity and the taxation and the how to manage this can become a real interruption for people's day to day lives. When ideally in my opinion, it shouldn't be. Again, you're doing this to support your goals and support your lifestyle. You're not doing it solely to be tax efficient and pile up money in a place that you can't get to it. 

Sara McCullough (14:46):

When we do this, inside a corporation, and we talk about tax efficiency, remember that this is tax deferral, this is not tax avoidance, and it's not tax nullification or the erasing of tax. And so that brings us to, when we take money out of our corporation, what do we call it? And when you own the corporation, you have a choice in what you call the money that comes out. And so today we're going to talk just about two of the ways to take money out. There are more options. They get pretty technical and probably not useful unless we're talking about your very own specifics. So when you are the owner of a corporation, you can choose to pay yourself either a salary, like you're an employee, or you can pay yourself dividends. And again, these terms are familiar to us as investors and as employees, when you're an employee of a larger corporation, you don't have a choice. You take your compensation in the way that the company gives it to you most traditionally in salary and/or bonus. When you own the corporation, and you can make decisions, you get to decide. All right. So, I've incorporated Bob's Big House of Noodles and I've decided to pay myself a salary. So what does that look like? 

Sara McCullough (16:36):

So, Bob's Big House of Noodles tax return is going to record my salary as a cost. My personal return is going to record my salary as T4 salary. I'm actually going to issue myself a T4 slip in the same way that if you were an employee of any big company. So, I'm going to pay CPP on my own tax return, Bob's Big House of Noodles is going to contribute CPP on my behalf. Now, again, this gets a little tricky because it's me owning the corporation and it's me declaring personal income. So am I paying both sides of the CCP? I am, but there are reasons to do that. So Bob's remit some CPP for me. I remit some on my own taxes. It comes to me on my T4. I also have RSP room when I pay myself a salary, because I'm an employee and it's T4 income. Bob's Big House of Noodles can create a health benefit plan for employees and, their family members and I can be a part of that. 

Sara McCullough (17:53):

So those are all good things and they increase my tax rate to a regular employee's tax rate. So what about this dividend option? I don't have to pay myself a salary when I'm the owner. I can choose to take dividends. And again, most of us are familiar with the idea of dividends because we probably, if we've invested somewhere, we own a stock that pays us dividends. And in the investing conversation, I say to clients, when a stock pays you dividends, it's kind of like, it pays you rent for you to hold the stock over time. 

Sara McCullough (18:40):

When you have your own corporation and you own shares, you can declare a dividend out of the profits of your corporation. And so my personal tax return, isn't going to have anything on the T4 income line, it's going to have a number on the dividend line, and it's a dividend received from a Canadian corporation. There are tax advantages to this. Sometimes in the tens of thousands of dollars per year for the same amount of money coming to me in salary versus a dividend. So Bob's Big House of Noodles tax return records that a dividend was paid to a shareholder. My personal tax return may show no T4 income, but it does record a dividend income from a Canadian corporation. 

Sara McCullough (19:43):

Remember if this happens, yes, have I paid less in tax? I have. Both the federal tax rate and the provincial tax rates have been trying over the last 10 or so years to make this difference between salary and dividend, as small as possible. CRA's goal is that there's no difference because they don't like it. It feels like a loophole to them, but for a number of reasons, the difference is still there. But when I do this, neither Bob's Big House of Noodles or Sara McCullough are paying into CPP now. And I have no RSP room because I'm actually not an employee of the corporation when I pay myself a dividend. So no health benefit plan is possible in here either because I'm not an employee. 

Sara McCullough (20:45):

So yes, to tax savings, no to some other things that may be important to you either now or in the future. And again, it's important that you understand the implications of the choices that you're making today. How does that change your tomorrow? And is that tax savings enough to offset what you've given up? And a lot of the work that I do with my incorporated clients are around what happens if you continue this, when might be an ideal time for you to make a change, and is there an optimal division between salary and dividends? You can do both. It doesn't have to be all of one, and none of the other, you can decide. So there's a lot of really great work that can be done in there on how do you pay yourself? 

Sara McCullough (21:51):

So I've talked about some of the benefits that come along with your income choice, and I've talked about RSPs, but maybe some of you are thinking, but if I leave my big corporation and start my own business, I won't have a pension plan. And those are really valuable. When you incorporate, even if it's just you, you can have your own pension plan because your corporation can follow the same rules as every other company. And granted there are fewer and fewer every year that offer pension plans. And I mean, the defined benefit pension plans, not the, put something in, pick your own investments, good luck with that pension plans. Those are good too. But if you are someone who is looking for security, looking for predictability and has a very predictable cash flow, you can actually set up your own defined benefit pension plan. 

Sara McCullough (22:58):

So if I incorporate Bob's Big House of Noodles, it can actually offer me a pension plan. I need that T4 salary though, because remember pension plans only are offered to employees. So I need that T4 salary. I need to have discipline because I need to contribute every year, but the tax deferral and the tax sheltering room that is possible with an individual pension plan, can sometimes make a huge difference to clients in a very short time. One of my recent clients, when we first started working together, he does have his own corporation. And I said at the end of our first meeting, have you looked at an individual pension plan because he did have surplus money in the corporation. He was declaring a very high income personally, so he was quite far into that top tax bracket. 

Sara McCullough (23:58):

And he said, “well, I asked my investment advisor and he said it wasn't worth it”. So I did a quote for him for his initial plan. And it turned out that the difference between this client setting up an individual pension plan and continuing to declare the salary that he was declaring and contributing to an RSP. The difference in tax deferral alone was $300,000 over five years. That seems like it's worth a conversation. There were other benefits that came from that. And we then had to talk about how does he work with this individual pension plan when he's retired or when he leaves the company. And then my client did have to negotiate with his partners because he's not the sole business owner in this case, but there was so much value in there for him based on his personal circumstances that he did end up going ahead with it. 

Sara McCullough (25:08):

His partners did not. So again, this does not have to be an all or nothing conversation when you own the corporation either individually or with partners. So that gives you a few options in the, how do you get money out. Again, related to the corporation being separate from you. The corporation doesn't die when you do, because it's separate. So it actually needs its own power of attorney documents and its own will, ideally. In the last couple of episodes, we've talked about power of attorney. That was the episode I did with Blair Botsford. I did a solo episode covering your estate and what do wills do? And a in episode 10, Tony Salgado and I talked about how do you use insurance to buffer the taxes that can happen when you have a corporation? 

Sara McCullough (26:07):

So in this episode, all I want to cover here is when you incorporate, it's incredibly important that you follow through and protect that corporation, because remember it is an extension of you it's legally separate, but it is an extension of you. And if you did this to benefit yourself, your family and your goals, you've gotta go all the way and protect it. Because we don't wanna give up those benefits when you are not here. We've talked a little bit about the corporation being separate from you, so it doesn't die when you do, but what will happen as a shareholder, is you will deal with the taxes and the capital gains on your shares personally, when you die. So do you see the disconnect there? I'm gonna deal personally with the gains in my corporation. So I've had a successful run with Bob's Big House of Noodles, and I've managed to keep money in the business and it's worth something. And then I die. 

Sara McCullough (27:27):

Well, that's a capital gainaAs far as CRA is concerned. They don't necessarily differentiate between shares of TD bank or shares of GM or shares of Air Canada and shares in Bob's Big House of Noodles. For them, the basic transaction is all the same. You've gotta deal with that gain in value. When I opened Bob's, it was worth nothing. I didn't have any money in there. And when I died, if I've got money in there, if I've managed to save $600,000 in there, CRA wants the gain between zero and $600,000. They want some tax on that. And that goes on my personal final tax return, but Bob's didn't die. 

Sara McCullough (28:18):

So where's that money coming from. So that's where planning is important for a corporation and for families. For so many reasons. Whether my kids want to keep Bob's Big House of Noodles or not, whether I can sell it or not, giving up money in tax that I don't have to isn't anybody's goal. And the really tricky part about corporations and shares and shareholders dying, CRA doesn't tax the same dollar twice unless you let them. And if you do not have an estate plan for your corporation, and you do not have clear instructions on how to deal with your shares and how to deal with the corporation, you WILL pay tax twice. 

Sara McCullough (29:20):

When I said, theoretically, I died and Bob's Big House of Noodles was worth $600,000, there's only 12 months that my executors have to deal with both my personal final tax return and a tax return for Bob's Big House of Noodles. Otherwise, I'm going to personally pay on that 600,000 and Bob's will pay corporately on that 600,000. That is double taxation and nobody volunteers for that. If you don't have an estate plan for your corporation, you are effectively volunteering for double taxation, unless you're surviving family can get those two things filed within 12 months. The average uncomplicated estate takes about 12 to 18 months to settle. As soon as you have a corporation, you are a complex estate. 

Sara McCullough (30:29):

So again, when you work hard at your business and you work hard at planning, don't leave this part out. It's so important for everybody else connected to you. I hope today's episode gave you a bit of an overview of the what's, whys, and hows of a corporation. To understand fully what it can do for you to start, you need your own individual advice. If you already have a corporation and you're feeling like maybe you're not the one in charge, or maybe you would like to do some things, and you're feeling a little bit penned in by the fact that it's in a corporate account and it's not in your own name, there's a way to solve that. 

Sara McCullough (31:24):

In life, we all have pieces scattered here and there, whether or not they involve your corporation, your compensation, salary versus dividends, and how many wills you've got. And from time to time, we need someone who can cut through the noise. Someone who not only gets to know you as a person and maybe as a business, but also can really show and make sense of your financial plan, not just the numbers, but truly what the numbers mean for you. This relationship and this plan belongs to you, not your planner. I'm Sara McCullough. Thank you for listening to Sara Makes Sense. 

Disclaimer (32:07):

The information in this podcast is intended for general information and illustrative purposes. For advice relevant to your a specific situation, meet with a qualified financial planner, lawyer, or accountant before making any changes to your situation. Sara's designations and licensing include: Certified Financial Planner, Registered Financial Planner, Certified Divorce Financial Analyst, and holding an insurance license.