The Best of The Blunt Bean Counter - Proprietorship or Corporation - What is the Best for Your (New) Business?

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a November, 2011 blog post on whether you should incorporate a new

or start as a proprietorship?  I also address the logical follow-up question for those that have already started their business as a proprietorship:  when should they convert their proprietorship into a corporation?

Proprietorship or Corporation - What is the Best for Your (New) Business?

Corporation – Non-Tax Benefit

The number one non-tax reason to incorporate a business is for creditor proofing. Generally, a corporation provides creditor protection to its shareholder(s) through its limited liability status, a protection not available to a proprietorship. (It is important to note that certain types of professional corporations while protecting your personally from corporate liability, do not absolve the individual professional from personal professional liability). Where an incorporated business is sued and becomes liable for a successful claim, the only assets exposed to the creditors are the corporate assets, not the shareholders personal assets.

In order to mitigate the exposure that a potential claim could have on corporate assets, a holding company can be incorporated. Once the holding company is incorporated, the active corporation can transfer on a tax-free basis the excess cash and assets to the holding company (as discussed in my blog creditor proofing corporate funds) to insulate those assets from creditors. The assets in the holding company cannot be encroached upon if there is a lawsuit against the operating company unless there was some kind of fraudulent conveyance.

The inherent nature of certain businesses leads to the risk of lawsuits, while other business types have limited risk of a lawsuit. Thus, one of your first decisions upon starting a business is to determine whether your risk of being sued is high and if so, you should incorporate from day one.

Corporation – The Tax Benefits

There are several substantial income tax benefits associated with incorporation:

1) The Lifetime Capital Gains Exemption

If you believe that your business has substantial growth potential and may be a desirable acquisition target in the future, it is usually suggested to incorporate. That is because on the sale of the shares of a Qualifying Small Business Corporation, each shareholder may be entitled to a $824,177 capital gains exemption. So for example, if you, your spouse and your two children are shareholders of the family business (often through a family trust), you could potentially sell your business for $3,300,000 tax-free in the future. It should be noted that typically businesses that are consulting in nature, have limited value, since the value of the company is the personal goodwill of the owner.

Where you start your business as a proprietorship, it is still possible to convert the proprietorship into a corporation on a tax-free basis and to multiple the capital gains exemption going forward. A couple of points are worth noting here: (1) incorporating a proprietorship after the business has been operating for a few years may result in substantial legal, accounting and valuation fees; and (2) the value of the business up to the date of incorporation will belong to you and will be reflected in special shares that must be issued to you (assuming you will include other family members as shareholders in the new corporation).

For example, let's say you operate a successful business which you started as a proprietorship because you were unsure of whether it would be successful. The business has taken off and you have engaged a valuator to value the business prior to incorporating. The valuator has determined that the fair market value of your business today is worth $500,000. Upon incorporation, the $500,000 of value would be crystallized in special shares that would be owned by you. The new common shares that would be issued would only be entitled to the future growth of the business above and beyond the $500,000 and thus, any future capital gains exemptions for the new common shareholders would only accrue on the value in excess of $500,000.

2) Income Splitting

A corporation provides greater income splitting opportunities than a proprietorship. With a corporation it is possible to utilize discretionary shares that allow the corporation to stream dividends to a particular shareholder or shareholders (e.g. a spouse or a child 18 years of age or older) who are in lower marginal income tax brackets than the principal owner-manager.

Dividends are paid with after-corporate tax dollars from the business, whereas salaries, the alternative form of remuneration, are paid with pre-tax dollars and are generally a deductible business expense. The deductibility of a salary by a business is subject to a “reasonability test”. In order to deduct a salary from the business’ income it must be considered “reasonable”. Unfortunately, there is no defined criteria as to what is considered “reasonable”; however, paying a family member a salary of $50,000/annually who has little or no responsibilities within the business is likely not “reasonable”. However, with dividends there is no such “reasonability test”, so paying a family member a dividend of $50,000 even though she/he may have little or no responsibilities within the business is perfectly acceptable. Salaries to family members can be paid in an incorporated business or unincorporated business; however, the dividend alternative is unique to a corporation. Sole proprietors cannot pay themselves a salary; they receive draws from the proprietorship.

3) Income Tax Rate

The first $500,000 of active business income earned in a corporation is currently subject to an income tax rate of only 15.0%  in Ontario. Since the personal rate on income can be as high as 53.53%, income earned within a corporation potentially provides a very large income tax deferral, assuming these funds are not required personally for living expenses. This potential 38% deferral of income tax allows you to build your business with pre-tax corporate dollars. It should also be noted that once you take the money from the corporation, in many cases you essentially pay the deferred 38% tax as a dividend.

Corporations – The Fine Print

1) Expenses

Many people want to incorporate their business because they feel they will be able to deduct many more expenses in a corporation. In a general, that is an income tax fallacy. For all intents and purposes, the deductions allowed in a proprietorship are virtually identical to the deductions permitted in a corporation.

2) Professional and Compliance Costs and Administrative Burdens

The costs to maintain a corporation are significantly larger than for a proprietorship. There are initial and ongoing legal costs and annual accounting fees to prepare financial statements and file corporate income tax returns. These costs can be significant in some cases and can even outweigh some of the tax benefits in certain situations.

In addition, the administrative burdens for a corporation are far greater and drive many a client around the bend. For example, in a proprietorship or partnership, the owner(s) can take out money from the corporation without payroll source deductions. This is not the case when the owner(s) take out money in the form of a salary from a corporation.

So Why Start as a Proprietorship?

If you do not have legal liability concerns and you cannot avail yourself to the enhanced income splitting opportunities with family members a corporation may provide, starting as a proprietorship keeps your costs down and reduces your compliance and administrative issues. More importantly, since most people need whatever excess cash their business generates in its early years to live on, there is generally little or no tax benefit from incorporating a business initially. Finally, a proprietorship essentially provides for an initial test period to determine the viability of the business and if there are business losses, the owner(s) can generally deduct these losses against his or her other income.

When to Incorporate your Proprietorship?

In my opinion, you should incorporate your proprietorship once it has proven to be a viable business and once it has begun to generate cash in excess of your living requirements, so that you can take advantage of the 30% tax deferral available in a corporation.

Once you satisfy the above two criteria and incorporate, you will then benefit from creditor protection and the potential income splitting opportunities with other family members (assuming you want to include other family members as shareholders) and potentially the capital gains exemption or multiplication of the capital gains exemption if you include other family members in the corporation.

There is no “one shoe fits all” solution in determining whether to incorporate a new or ongoing business; however, the answer should become clearer once you address the issues I have outlined in this blog.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Best of The Blunt Bean Counter- Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company?

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a June, 2012 post on whether your corporation's shareholder should be a family trust or holding company.

This determination is a very complex and requires analysis by a tax expert. If you are considering a family trust, you must obtain professional advice to ensure you do not trip over any tax "land mines".

Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company?

I am often asked by clients incorporating a new company, whether they should hold the shares of the new corporation directly or whether they should utilize a holding company or a family trust.

The exact same question often arises a second time, years later, when a business has been successful and the shares of the corporation have been held by the client and/or their spouse directly and the client is now contemplating whether it makes sense to introduce a holding company or family trust into their corporate ownership structure, for creditor proofing and/or estate planning purposes.

I have discussed utilizing a holding company and introducing a family trust as a shareholder of a private corporation in prior blogs. Today I will discuss these alternative structures in context of a newly incorporated business and a mature business.

When a person decides to start a new business and incorporates (see my blog on whether to start a business as a proprietorship or corporation) there is often a level of uncertainty as to whether the new venture will be successful and cost control is often paramount. Thus, most people opt to keep their corporate structure simple (which really means, they do not want to spend money on lawyers and accountants to set-up holding companies and trusts) which is very understandable.

However, if you have the resources upon incorporation, you may wish to consider having a family trust own the shares of the private corporation rather than directly owning the shares or using a holding company from the outset. The two reasons you may wish to consider this corporate structure are as follows: (1) you can have a holding company as a beneficiary of a family trust which can provide all the benefits of a direct holding company; and (2) a family trust provides the ultimate in tax planning flexibility.

There are several benefits to having a family trust as a shareholder of your private company (I am assuming your corporation is an active company, not an investment company, for which the above is problematic). If the company is eventually sold, a family trust potentially provides for the multiplication of the $750,000 lifetime capital gains exemption on a sale of qualifying small business corporation shares (as of July, 2016, the exemption has risen to $824,177). That is, it may be possible to allocate the capital gain upon the sale to yourself, your spouse, your children or any other beneficiaries of the trust, resulting in the multiplication of the exemption and creating substantial income tax savings. For example: where there are four individual beneficiaries of a family trust, the family unit may be able to save as much as $700,000 (closer to $880,000 as of July, 2016) in income tax if a corporation  is sold for $3,000,000 ($3,300,00 as of July, 2016) or more . In addition, where your children are 18 years of age or over, the family trust can receive dividends from the family business and allocate some or all of the dividends to the children. The dividends must be reported in the tax return of the child, but in many cases, the dividends are subject to little or no tax (if a child has no other income, you can allocate almost $40,000 in dividends income tax-free).

Finally, where you have surplus earnings in a corporation and you wish to creditor proof those earnings, but do not want to allocate those funds to your spouse or your children, you may be able to allocate those funds tax-free to the holding company if it is a beneficiary of the trust. This provides for an income tax deferral of the personal taxes until the holding company pays a dividend to its shareholders.

So you may be asking “Mark, why would I ever not choose a family trust? Some of the reasons are as follows:

1. The initial accounting and legal costs may be as high as $8,000 - $12,000.

2. You may not have children or, if you do have children, they are young and you cannot allocate them dividends without the dividends being subject to the “Kiddie Tax” (a punitive income tax applied when minors receive dividends of private companies directly or through a trust).

3. You are not comfortable with allocating to your children any capital gains from a sale of the business and/or any dividends since legally that money would belong to them.
4. If the business fails, it may be problematic to claim an Allowable Business Investment Loss (a loss that can be deducted against any source of income) that would otherwise be available if the shares of the company were held directly by an individual.
5. There are some income tax traps beyond the scope of this blog post when a holding company is a beneficiary.

As discussed in the opening paragraph, once a business is established and has become successful, clients often again raise the issue of whether they should introduce a holding company or a family trust into the corporate ownership structure. At this stage, a holding company can easily be introduced as a shareholder. The mechanics are beyond the scope of this blog but the transaction can take place on a tax-free basis. However, the holding company essentially only serves one purpose, that being creditor proofing. A holding company is also often problematic, as the level of cash the holding company holds can put it offside of the rules for claiming the lifetime capital gains exemption if the business is sold in the future. Thus, you may wish to consider utilizing a family trust, unless you do not have children or do not anticipate being able to sell the corporation.

If one waits until the business is successful to introduce a family trust, as opposed to introducing one as an original shareholder when the business is first incorporated, the value of the business as at the date of the reorganization must first be attributed to the original owner(s) utilizing special shares (typically referred to as an estate freeze). This means the beneficiaries of the trust only benefit from the future growth of the corporation (i.e.: if the corporation is worth $2,000,000, the parent(s) are issued shares worth $2,000,000 and the children will only benefit on any increase in value beyond the $2,000,000). The costs of introducing a family trust with a holding company beneficiary as part of an estate freeze could be as high as $15,000 -$20,000 as a business valuation is often required.

The above discussion is very complex. The key takeaway should be that having a holding company as a direct shareholder of an operating company, may not always be the most tax efficient decision. A family trust with a holding company beneficiary may be the more appropriate choice depending upon the circumstances.

In any event, believe it or not, the above discussion has been simplified and you should not even consider undertaking such planning without consulting a professional advisor to understand the issues related to your specific fact situation to ensure the planning makes sense and that you are not breaching any of the hidden income tax traps.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

What Small Business Owners Need to Know - Section 85 Rollovers

Section 85 of the Income Tax Act ("Act") provides for the transfer of certain assets with inherent tax liabilities to a corporation on a tax-deferred basis. Thus, accountants often utilize this section of the Act, to meet many of the objectives small business owners have.

Section 85 is most commonly used as follows:

1. Incorporation of a business – A sole proprietor has decided that their business is growing and ready for the next stage (incorporation). They can transfer all of their business assets to the new corporation under section 85.

2. Sale of a proprietorship – Section 85 helps sole proprietors looking to sell their business utilize the capital gains exemption by providing under certain circumstances for the transfer of their assets to a new corporation in exchange for shares; and those new shares are sold shortly thereafter. The typical 24-month holding period requirement for the use of the capital gains exemption will typically not apply in this situation (this is technical and your accountant should be consulted to ensure all criteria are met).

3. Crystallization of capital gains – A small business owner can make use of the capital gains exemption by using section 85 to transfer their current shares back to their corporation in exchange for new shares redeemable at a higher value – usually up to the maximum capital gains exemption available. For 2016, the exemption is $824,117 which is indexed annually. See this this blog post on the complexities of accessing the capital gains exemption.

4. Estate planning and income-splitting – Section 85 can help transfer an individual’s business to a future generation and allow the growth of the business to accrue to the new generation also allowing for dividend sprinkling. However the attribution rules and “kiddie tax” should also be considered when dealing with minor children.

5. Asset Protection – Section 85 allows small business owners to transfer assets usually land and building used in their active business out of their operating company to a holding company on a tax-deferred basis.

Some Technical Details

Section 85 is a valuable tool for corporate transfers because of the flexibility provided by a tax attribute known as the elected amount (“EA”). The parties involved in the transaction (typically the small business owner personally and corporation they own) can choose within limits, what the EA is and that becomes the deemed proceeds of disposition of the selected assets. Thus, in most transactions the parties elect the EA to be the adjusted cost base of the asset being transferred and thus, there is no gain, since the EA is the same as the cost. For example: if you have an asset with a cost base of $100 and a fair market value of $100,000, you could elect at $100 to avoid any adverse tax consequences.

If you elect a higher EA than the adjusted cost base, a capital gain will result. In cases where a small business owner wants to “crystalize” their capital gains exemption, they will often elect to trigger a gain equal to their capital gains exemption to bump-up their cost base of their shares and thus the small business owner pays no tax as their capital gains exemption eliminates the capital gain, however, alternative minimum tax may sometimes apply.

In order for subsection 85(1) to apply, both the taxpayer and the corporation must jointly elect in prescribed form T2057 – Election on disposition of property by a taxpayer to a taxable Canadian Corporation. There are various administrative matters that need to be considered when filing this election.

Section 85 is probably one of the most powerful and most utilized tax planning tools for tax practitioners. Therefore careful planning should be undertaken. When planning to utilize section 85 rollover, the below factors should be considered or adverse tax consequences could apply!

1. What types of property can be transferred? Attention needs to be taken when determining what types of property to transfer under section 85. The most commonly mistaken property that cannot be transferred is real property held as inventory i.e. land and building (Note: most people hold their real estate as capital property and not inventory). However other planning can be achieved to rollover real property held as inventory to a corporation on a tax deferred basis.

2. Should you transfer accounts receivable under section 85(1)? Other provisions of the Act should be considered to allow for the most tax efficient rollover of A/R.

3. What type of property can be received for transferring assets to the corporation? Can you receive cash or a promissory note in return without triggering punitive income tax consequences?

4. Do you have to receive shares in return for the assets being transferred? Can you receive a fraction of a share?

5. What type of corporation can you transfer the assets to on a tax deferred basis? Can it be a non-resident corporation or non-resident individual?

6. Determining the amount to elect if intellectual property is being transferred (i.e. goodwill)?

Once the assets are transferred to the corporation, there is no mirror provision available to roll them back out. It is generally advisable to include a price adjustment clause in case CRA does not agree with the estimated FMV of the property transferred (it is recommended that a valuation be undertaken to support the fair market value). The CRA recently published an Income Tax Folio: S4-F3-C1 – Price Adjustment Clauses that deal with the various types of situation in which a price adjustment should be included.

Other items to remember include GST/HST. Usually this tax will apply to the transfer price or the FMV of the assets. However an election can often be made which would allow the transfer of the assets to be exempt from GST/HST if certain conditions are met.

Section 85 is a very powerful provision of the Act and must be used with care. All of the above questions should be considered prior to commencing a rollover. There are other issues not mentioned above due to complexity. Always consult a tax specialist when dealing with rollovers.

[Thanks to Lorenzo Bonanno of BDO Canada LLP, for his assistance with this blog post]

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Small Business Owners - Get on my Mailing List

If you are an owner-manager and/or a shareholder in a corporation and have not signed up for my corporate mailing list, please email me at bluntbeancounter@gmail.com

I will be sending out specific mailings on matters of importance to small business owners and I am considering, depending upon the interest, holding a roundtable for small business owners who are in the Toronto area. [I have not yet sent out a mailing, as I have been busy with December 31st corporate year-ends due June 30th. I will for sure send out something this summer].

Do It Yourself Accountants and Lawyers

In October, I provided RateHub.ca (an excellent mortgage site) with the following literacy tip for their Facebook page: “Don’t confuse financial literacy with the ability to execute financial, monetary and income tax transactions.” I admit, this tip was a little harsh in tone, but I continue to see more and more misguided souls who think they are tax, legal and financial experts because they have read an article or two, in a blog or book. This issue has arisen in part, because DIY (“Do it Yourself”) investors have become emboldened as some (definitely not all) have been able to successfully manage their own investment portfolios using index funds and “Couch Potato” strategies.

The DIY movement which preaches self-sufficiency for your financial affairs is in my opinion causing many people to consider themselves multi-disciplinary experts when they only have an understanding of a small part of the issue, which can result in costly legal, tax or financial miscues.

I see two distinct issues here.

1. Too many people believe everything they read (especially what they read on this blog :).

2. Most tax and legal related information is general in nature. The writers often do not provide the technical details that can make or break a tax or estate plan because of space constraints and because they need to keep the articles "readable". I have noted significant tax planning errors in the popular “Financial Makeover” that many newspapers publish on the weekend. These errors reflect that even financial planners over-step their expertise and think they are also tax planners and lawyers.

DIY Tax Experts

 

Below, I have some common tax related issues that arise with DIYers.

Personal Tax Returns

 

If you have a simple tax return with a few T4, T5 and RRSP slips, I have no issue with you doing your own return; although you can still easily be caught by elections and one-time events you may not be aware of. However, if you have self-employment income or rental income, in many cases, being a DIY tax expert can be penny-wise and pound foolish. 

With respect to business and self-employment income, people tend to make some outrageous claims for their home office (that could impair their principal residence exemption) and auto usage that are red flags for the CRA. In addition, they often claim non-deductible expenses such as clothing and life insurance.

For those people with rental properties, I’ve seen people make a mess in the structuring of the initial ownership, their reporting of the personal use of the property (if any) and how they report large repairs (they claim capital expenses as repairs and repairs as capital expenses).

Probate and Estate Planning

I have written extensively about probate and property transfer landmines, that DIYers set-off when undertaking their own estate planning.

If you transfer property to anyone other than your spouse, you have a deemed sale for tax. I have seen people transfer cottages, stocks, principal residences (not typically an issue upon transfer, but an issue after transfer in that the tax-free status of your home is lost on the portion transferred). You should never be a DIY tax planner when you transfer property of any kind, the tax traps are extensive.

Cocktail parties tend to breed DIY estate planning experts who inform anyone within shouting distance to transfer property to their family members to avoid probate fees. I call this double martini/double trouble advice. The problem is that the CRA does not recognize these transfers where you don’t also transfer the beneficial ownership (real ownership) and thus, a property transfer “for show” does not legally reduce your probate fees on death (at least in the CRA's eyes. Some estate planners are less concerned as they say the provinces do not look into the history of ownership). Even if you feel the transfer is effective for probate purposes, these transfers are not effective for income tax purposes. More importantly, from an estate perspective, these transfers often become catalysts for family litigation. Children litigate over whom mom and dad actually left the property to; where their parents only transferred the property to one of their children for the sake of simplicity, such as putting a child's name on a joint bank account. 

Elections and One-Time Events

In 1994, the government eliminated the $100,000 capital gains exemption, but allowed an election to “bump-up” the value of property you owned at that time up to $100,000. Although this was widely reported in the press, you would not believe how many clients I have picked-up since 1994 that did not make the election on property that had appreciated significantly, typically their cottage or other real estate investments. This omission has cost many people approximately $25,000 in tax that need not have been paid.

Another election that is commonly missed by DIYers is the 45(2) election where you change the use of your home to a rental property. Without this election, you are deemed to sell your home at the time you change its use. While typically this does not result in any income tax at the time (as your principal residence is tax-free), by not making the election, you may owe income tax on the future sale of your home that may have been avoided by making the election.

DIY Legal Experts

DIY legal errors are often errors of omission as much as errors of commission. I discuss two of those areas below.

Incorporation

DIYers love to incorporate their own companies. It is cheap and fairly easy to do. The problem is that they almost always limit the share attributes which often requires articles of amendment in the future and may also create problems on the sale of the corporation. In addition, many "DIY lawyers" issue common shares to themselves and their spouses, but almost always never consider discretionary shares that provide for the payment of all or a portion of the dividends to a lower income spouse for income splitting purposes (I will have a future blog on this topic). In the rare circumstance that they do consider discretionary shares, they often do not create the distinction in classes necessary for discretionary shares.

Wills

There are many do it yourself will kits. While these kits may ensure you have a legal will, they are simple in nature and in many cases, your life is not as simple as ticking a few basic boxes. I truly cannot comprehend

why anyone with any assets of a substantial nature would not pay for a proper will and power of attorneys for both your competency and financial affairs. This does not even account for the fact in certain provinces you can have a second will to avoid probate on the value of your private corporation, amongst other items.

My advice; do not be seduced by your own financial literacy and overreach your expertise. Just accept that professional advice is often a necessary evil.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company?

I am often asked by clients incorporating a new company, whether they should hold the shares of the new corporation directly or whether they should utilize a holding company or a family trust.

The exact same question often arises a second time, years later, when a business has been successful and the shares of the corporation have been held by the client and/or their spouse directly and the client is now contemplating whether it makes sense to introduce a holding company or family trust into their corporate ownership structure, for creditor proofing and/or estate planning purposes.

I have discussed utilizing a holding company and introducing a family trust as a shareholder of a private corporation in prior blogs. Today I will discuss these alternative structures in context of a newly incorporated business and a mature business.

When a person decides to start a new business and incorporates (see my blog on whether to start a business as a proprietorship or corporation ) there is often a level of uncertainty as to whether the new venture will be successful and cost control is often paramount. Thus, most people opt to keep their corporate structure simple (which really means, they do not want to spend money on lawyers and accountants to set-up holding companies and trusts) which is very understandable.

However, if you have the resources upon incorporation, you may wish to consider having a family trust own the shares of the private corporation rather than directly owning the shares or using a holding company from the outset. The two reasons you may wish to consider this corporate structure are as follows: (1) you can have a holding company as a beneficiary of a family trust which can provide all the benefits of a direct holding company; and (2) a family trust provides the ultimate in tax planning flexibility.

There are several benefits to having a family trust as a shareholder of your private company (I am assuming your corporation is an active company, not an investment company, for which the above is problematic). If the company is eventually sold, a family trust potentially provides for the multiplication of the $750,000 lifetime capital gains exemption on a sale of qualifying small business corporation shares. That is, it may be possible to allocate the capital gain upon the sale to yourself, your spouse, your children or any other beneficiaries of the trust, resulting in the multiplication of the exemption and creating substantial income tax savings. For example: where there are four individual beneficiaries of a family trust, the family unit may be able to save as much as $700,000 in income tax if a corporation  is sold for $3,000,000 or more. In addition, where your children are 18 years of age or over, the family trust can receive dividends from the family business and allocate some or all of the dividends to the children. The dividends must be reported in the tax return of the child, but in many cases, the dividends are subject to little or no tax (if a child has no other income, you can allocate almost $40,000 in dividends income tax-free).

Finally, where you have surplus earnings in a corporation and you wish to creditor proof those earnings, but do not want to allocate those funds to your spouse or your children, you may be able to allocate those funds tax-free to the holding company if it is a beneficiary of the trust. This provides for an income tax deferral of the personal taxes until the holding company pays a dividend to its shareholders.

So you may be asking “Mark, why would I ever not choose a family trust? Some of the reasons are as follows:

1. The initial accounting and legal costs may be as high as $7,000 - $10,000.

2. You may not have children or, if you do have children, they are young and you cannot allocate them dividends without the dividends being subject to the “Kiddie Tax” (a punitive income tax applied when minors receive dividends of private companies directly or through a trust).

3. You are not comfortable with allocating to your children any capital gains from a sale of the business and/or any dividends since legally that money would belong to them.

4. If the business fails, it may be problematic to claim an Allowable Business Investment Loss (a loss that can be deducted against any source of income) that would otherwise be available if the shares of the company were held directly by an individual.
5. There are some income tax traps beyond the scope of this blog post when a holding company is a beneficiary.

As discussed in the opening paragraph, once a business is established and has become successful, clients often again raise the issue of whether they should introduce a holding company or a family trust into the corporate ownership structure. At this stage, a holding company can easily be introduced as a shareholder. The mechanics are beyond the scope of this blog but the transaction can take place on a tax-free basis. However, the holding company essentially only serves one purpose, that being creditor proofing. A holding company is also often problematic, as the level of cash the holding company holds can put it offside of the rules for claiming the $750,000 lifetime capital gains exemption if the business is sold in the future. Thus, you may wish to consider utilizing a family trust, unless you do not have children or do not anticipate being able to sell the corporation.

If one waits until the business is successful to introduce a family trust, as opposed to introducing one as an original shareholder when the business is first incorporated, the value of the business as at the date of the reorganization must first be attributed to the original owner(s) utilizing special shares (typically referred to as an estate freeze). This means the beneficiaries of the trust only benefit from the future growth of the corporation (ie: if the corporation is worth $2,000,000, the parent(s) are issued shares worth $2,000,000 and the children will only benefit on any increase in value beyond the $2,000,000). The costs of introducing a family trust with a holding company beneficiary as part of an estate freeze could be as high as $15,000 -$20,000 as a business valuation is often required.

The above discussion is very complex. The key takeaway should be that having a holding company as a direct shareholder of an operating company, may not always be the most tax efficient decision. A family trust with a holding company beneficiary may be the more appropriate choice depending upon the circumstances.

In any event, believe it or not, the above discussion has been simplified and you should not even consider undertaking such planning without consulting a professional advisor to understand the issues related to your specific fact situation to ensure the planning makes sense and that you are not breaching any of the hidden income tax traps.

Top Canadian Investing Blogs

If you are still reading at this point (yes, I know, I break every rule about having a maximum of 400 words per blog), Jeremy Biberdorf of www.modestmoney.com has been kind enough to nominate my blog in his poll for the top Canadian Investing Blogs (not sure my blog fits that category, but I appreciate the consideration anyways). If you have a minute, please visit this link and vote for me. My goal is to escape last place :).

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Proprietorship or Corporation - What is the Best for Your (New) Business?

I am often asked by readers and clients, whether they should incorporate a new business or start as a proprietorship? A logical follow-up question for those that have already started their business as a proprietorship is: when should they convert their proprietorship into a corporation? I will address both these questions today.

Corporation – Non-Tax Benefit

The number one non-tax reason to incorporate a business is for creditor proofing. Generally, a corporation provides creditor protection to its shareholder(s) through its limited liability status, a protection not available to a proprietorship. (It is important to note that certain types of professional corporations while protecting your personally from corporate liability, do not absolve the individual professional from personal professional liability). Where an incorporated business is sued and becomes liable for a successful claim, the only assets exposed to the creditors are the corporate assets, not the shareholders personal assets.

In order to mitigate the exposure that a potential claim could have on corporate assets, a holding company can be incorporated. Once the holding company is incorporated, the active corporation can transfer on a tax-free basis the excess cash and assets to the holding company (as discussed in my blog creditor proofing corporate funds) to insulate those assets from creditors. The assets in the holding company cannot be encroached upon if there is a lawsuit against the operating company unless there was some kind of fraudulent conveyance.

The inherent nature of certain businesses leads to the risk of lawsuits, while other business types have limited risk of a lawsuit. Thus, one of your first decisions upon starting a business is to determine whether your risk of being sued is high and if so, you should incorporate from day one.

Corporation – The Tax Benefits

There are several substantial income tax benefits associated with incorporation:

1) The Lifetime Capital Gains Exemption

If you believe that your business has substantial growth potential and may be a desirable acquisition target in the future, it is usually suggested to incorporate. That is because on the sale of the shares of a Qualifying Small Business Corporation, each shareholder may be entitled to a $750,000 capital gains exemption. So for example, if you, your spouse and your two children are shareholders of the family business (often through a family trust), you could potentially sell your business for $3,000,000 tax-free in the future. It should be noted that typically businesses that are consulting in nature, have limited value, since the value of the company is the personal goodwill of the owner.

Where you start your business as a proprietorship, it is still possible to convert the proprietorship into a corporation on a tax-free basis and to multiple the capital gains exemption going forward. A couple of points are worth noting here: (1) incorporating a proprietorship after the business has been operating for a few years may result in substantial legal, accounting and valuation fees; and (2) the value of the business up to the date of incorporation will belong to you and will be reflected in special shares that must be issued to you (assuming you will include other family members as shareholders in the new corporation).

For example, let's say you operate a successful business which you started as a proprietorship because you were unsure of whether it would be successful. The business has taken off and you have engaged a valuator to value the business prior to incorporating. The valuator has determined that the fair market value of your business today is worth $500,000. Upon incorporation, the $500,000 of value would be crystallized in special shares that would be owned by you. The new common shares that would be issued would only be entitled to the future growth of the business above and beyond the $500,000 and thus, any future capital gains exemptions for the new common shareholders would only accrue on the value in excess of $500,000.

2) Income Splitting

A corporation provides greater income splitting opportunities than a proprietorship. With a corporation it is possible to utilize discretionary shares that allow the corporation to stream dividends to a particular shareholder or shareholders (e.g. a spouse or a child 18 years of age or older) who are in lower marginal income tax brackets than the principal owner-manager.

Dividends are paid with after-corporate tax dollars from the business, whereas salaries, the alternative form of remuneration, are paid with pre-tax dollars and are generally a deductible business expense. The deductibility of a salary by a business is subject to a “reasonability test”. In order to deduct a salary from the business’ income it must be considered “reasonable”. Unfortunately, there is no defined criteria as to what is considered “reasonable”; however, paying a family member a salary of $50,000/annually who has little or no responsibilities within the business is likely not “reasonable”. However, with dividends there is no such “reasonability test”, so paying a family member a dividend of $50,000 even though she/he may have little or no responsibilities within the business is perfectly acceptable. Salaries to family members can be paid in an incorporated business or unincorporated business; however, the dividend alternative is unique to a corporation. Sole proprietors cannot pay themselves a salary; they receive draws from the proprietorship.

3) Income Tax Rate

The first $500,000 of active business income earned in a corporation is currently subject to an income tax rate of only 15.5%  in Ontario. Since the personal rate on income can be as high as 46%, income earned within a corporation potentially provides a very large income tax deferral, assuming these funds are not required personally for living expenses. This potential 30% deferral of income tax allows you to build your business with pre-tax corporate dollars. It should also be noted that once you take the money from the corporation, in many cases you essentially pay the deferred 30% tax as a dividend.

Corporations – The Fine Print

1) Expenses

Many people want to incorporate their business because they feel they will be able to deduct many more expenses in a corporation. In a general, that is an income tax fallacy. For all intents and purposes, the deductions allowed in a proprietorship are virtually identical to the deductions permitted in a corporation.

2) Professional and Compliance Costs and Administrative Burdens

The costs to maintain a corporation are significantly larger than for a proprietorship. There are initial and ongoing legal costs and annual accounting fees to prepare financial statements and file corporate income tax returns. These costs can be significant in some cases and can even outweigh some of the tax benefits in certain situations.

In addition, the administrative burdens for a corporation are far greater and drive many a client around the bend. For example, in a proprietorship or partnership, the owner(s) can take out money from the corporation without payroll source deductions. This is not the case when the owner(s) take out money in the form of a salary from a corporation.

So Why Start as a Proprietorship?

If you do not have legal liability concerns and you cannot avail yourself to the enhanced income splitting opportunities with family members a corporation may provide, starting as a proprietorship keeps your costs down and reduces your compliance and administrative issues. More importantly, since most people need whatever excess cash their business generates in its early years to live on, there is generally little or no tax benefit from incorporating a business initially. Finally, a proprietorship essentially provides for an initial test period to determine the viability of the business and if there are business losses, the owner(s) can generally deduct these losses against his or her other income.

When to Incorporate your Proprietorship?

In my opinion, you should incorporate your proprietorship once it has proven to be a viable business and once it has begun to generate cash in excess of your living requirements, so that you can take advantage of the 30% tax deferral available in a corporation.

Once you satisfy the above two criteria and incorporate, you will then benefit from creditor protection and the potential income splitting opportunities with other family members (assuming you want to include other family members as shareholders) and potentially the capital gains exemption or multiplication of the capital gains exemption if you include other family members in the corporation.

There is no “one shoe fits all” solution in determining whether to incorporate a new or ongoing business; however, the answer should become clearer once you address the issues I have outlined in this blog.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.