Unlike a sole proprietor who is fully liable for the debts of the business, a shareholder is not responsible for debts or other liabilities incurred by the corporation. Of course, a shareholder who personally guarantees corporate debts is liable up to the amount guaranteed, and directors and officers can, in certain circumstances, be held liable for activities of the corporation. In general, however, your personal assets are protected from creditor claims and any lawsuits or other liabilities arising in the corporation.
One of the major reasons to incorporate is to obtain the Small Business Deduction. In order to provide tax support to small businesses, a small business deduction is provided to Canadian-controlled private corporations (CCPCs) on active business income up to specific income thresholds. For federal tax purposes, the small business deduction reduces the basic federal corporate income tax rate to approximately 13% for the first $200,000 of active business income of a CCPC. For provincial tax purposes, most provinces have increased their small business income limits from $200,000 over the past few years to provide further tax breaks for small businesses (including recent announcements by Nova Scotia and Newfoundland).
The small business deduction is effectively a tax deferral, which is maintained until the owner-manager removes the after-tax corporate profits from the corporation as a dividend. When this dividend is ultimately paid, the combined corporate tax and personal tax on the dividends generally approximates the amount of tax that would be paid if the business income was earned directly by the individual.
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There are definite tax advantages of being a self-employed individual. The biggest advantage is being able to deduct expenses from your income when you prepare your tax return each year. We'll review the type of expenses you can deduct, later in this bulletin.
You shouldn't be blinded by the tax advantages, however. There are other factors you need to consider. These include:
As an independent contractor, you will have to deal with the GST. The GST is charged at the rate of 7% on the supply of most goods and services. As an independent contractor, you will generally be in the business of supplying goods and services to your customers or clients. Therefore, you will likely have to collect the GST on your revenue and remit it to the government.
The GST does not have to be collected on all goods and services (known as "supplies" under the GST rules). Certain supplies are exempt from GST- if you're in the business of making these types of supplies you do not have to collect and remit the GST. Your BDO advisor can help you determine the GST implications of your particular business.
If you are in the business of producing taxable supplies you will have to register for the GST with the CRA. However, the news isn't all bad. If you have to collect and remit the GST on your revenue, you can claim a refund (known as input tax credits - ITCs) for the GST you pay on your expenses, including capital purchases. You have to file GST returns with the CRA to remit the GST you have collected, less any ITCs you are entitled to.
If you do business in eastern Canada you may have to register for the Harmonized Sales Tax (HST) instead of the GST. This tax, which is charged at the rate of 15%, applies to taxable supplies made in the provinces of Newfoundland , Nova Scotia and New Brunswick . In Québec, QST applies in a similar manner as the GST.
Many people use their cars for work or business and personally incur expenses in doing so. If this is your situation, you’ll want to be able to deduct those expenses against the related income. The Canada Revenue Agency has strict requirements for claiming automobile deductions that are designed to ensure that only true business-related expenses may be claimed. To substantiate your deduction, you’ll have to maintain detailed records of the expenses you incur and the kilometers you drive on income-earning activities.
Information isn’t enough, though. There are some complex rules that apply in determining how much of your expenses can actually be claimed. You should speak with your accountant to ensure you are calculating this properly. For further details refer to our publication entitled Automobile Expenses & Recordkeeping on BDO Canada website to determine whether you should be keeping records of automobile expenses, what types of expenses to track when using your car for work or business and the deductibility of those expenses.
Income splitting is the process of redirecting income within a family group to take advantage of the lower tax brackets, deductions and credits available to each family member. Income is split by transferring income-earning assets from high-income to lower-income family members. Generally speaking, the total tax on family income will be lowest when each member earns approximately the same level of income.
People are often surprised at the magnitude of tax savings that can be achieved through simple income splitting. As an example, assume an individual earns income which places him well into the top marginal tax bracket. By transferring enough income to another family member, he can bring that person’s income up to the cut-off for the top marginal bracket. Income previously taxed at the top rates will now be taxed in the lower brackets, with more after-tax cash remaining within the family unit.
There are rules that apply, so be sure to speak with your accountants. For income splitting, visit BDO Canada website for further details.
Make your spouse a partner of your unincorporated business.If you operate an unincorporated business in which your spouse is active, you may be able to establish that he or she is your partner, eligible to share in the profits or losses of the business.
To be considered a bona fide partner, your spouse must either devote a significant amount of his or her time, specified skills, or training to the business or must have invested his or her own property in the business. You must ensure that your spouse’s share of income is reasonable compared with the amount of work or capital put into the business. A partnership agreement is recommended.
If your spouse or children work in your business, consider paying them a salary. The salary must be reasonable given the services performed. A good rule of thumb is to pay them what you would have paid a third party for the same services. A record should be kept of the time actually spent and the services actually performed. When you pay salaries to your spouse or children, you usually must make withholdings for income tax, Canada/Quebec Pension Plan (for individuals over 18 years of age) and any applicable provincial payroll taxes. Liability for employment insurance will vary and should be discussed with your BDO advisor.
If your spouse is a director of your corporation, consider paying your spouse a director’s fee for services performed. A director’s services usually include attending directors’ meetings, directing the management and affairs of the business, approving financial statements, declaring dividends, approving changes to share capital and electing officers of the company. Note that your spouse will also be jointly liable with the other directors for the fulfillment of certain regulatory requirements, such as salary withholdings and GST collections.
If your spouse is required to pledge assets or to otherwise guarantee a business loan, he or she can be paid a fee by the business. Again, the amount paid must be reasonable in the circumstances. In determining reasonableness, one would look at the amount of the loan, subsequent ability of the business to repay the loan and the amount that would have otherwise been paid to an arm’s-length party to guarantee the loan. The fee will also help in establishing deductibility of the loan for your spouse, should the debt become bad and the guarantee ever be called.
Only income from property is subject to attribution. Income from a business is not. If your spouse has a promising business venture, you can provide interest-free financing without any attribution. If the venture is risky, you should consider that an interest-free loan would not qualify for capital loss treatment should the venture fail. If this is the case, you might want to make a capital contribution to the business as a partner and share in the start-up loss. When the business becomes profitable, you can make interest-free loans to the business for further expansion. A gift could also be used to finance a new venture. Your spouse’s share of profits from the venture can be invested by your spouse and would not be subject to income attribution.
If your spouse or children work for you, consider paying them salaries. Salaries paid reduce your income and are taxed in their hands, possibly at lower marginal tax rates than if the income had been paid to you. They also provide family members with earned income for RRSP contributions.
Any salary paid must be reasonable given the services performed. A good rule of thumb is to pay them what you would have paid a third party. A record should be kept of the time actually spent and the services actually performed.
Also, whenever you pay salaries to your spouse or children, ensure that withholdings for income tax, Canada/Québec Pension Plan (CPP/QPP), Employment Insurance (EI) and any applicable provincial payroll taxes are remitted as required. The salary and the amounts withheld for 2005 must be reported on T4 slips, which are due on or before February 28, 2006.
You should keep all records of your income, as well as your expenses. If your records are organized, not only will this save you time (and accounting fees) when you prepare your tax return, it will also help ensure you are prepared should the CRA decide to review your return. Write down the purpose of the expense on your receipt and keep it in an organized filing system, such as by type of expense (e.g., meals and entertainment, car and insurance expenses, etc.).
Receipts are crucial for all of your expenses. Here are some additional points to keep in mind.
RRSP contributions do not have to be deducted in the year in which they are made. The contributions can be deducted in that year or in any future year. You should consider deferring the deduction of your contribution if you don’t have much taxable income in the current year. By deferring the deduction to a year when your marginal tax rate is higher, you will save more in taxes. Remember, however, that delaying the deduction has a cost in prepaid tax as you will not be getting the benefit of the deduction until the future. Therefore, you also have to consider the time value of money when making the deduction of your RRSP contributions.