Corporations: A Comprehensive Guide to Tax and Financial Considerations
What Does "Incorporation" Mean?
Limited Liability
In this article, what we refer to as "incorporation" is the operation of a business within the legal construct of a limited liability corporation, which is an artificial entity whose characteristics have developed over the last century. Today, corporations have become the dominant form of business structure.
The purpose of the limited-liability corporation (also commonly but less precisely referred to as a "company") is to limit the liability for debts incurred in operating the business to the assets of the corporation, and no more. Thus, if assets are insufficient to cover the debts of the corporation, the corporation becomes insolvent or bankrupt, and the creditors take a loss. The shareholders of the corporation would, of course, lose whatever capital they had put into the corporation, but would not be liable to cover the losses of the corporation's creditors.
In today's complex and litigious business environment, however, there are ways that shareholders can still find themselves personally liable for the debts of a corporation. For example, banks usually require that shareholders voluntarily waive their basic liability limitation by giving personal guarantees for any loans advanced. In many cases, banks will refuse to lend if they do not get a personal guarantee. Further, in some situations, a corporate debt to Revenue Canada could be pursued to the shareholder level. Other statutes, such as recent changes to environmental protection laws, can empower governments or others to seek compensation from shareholders.
Corporations have indefinite life. Therefore, unless they become insolvent, corporations can last forever. In practice, they last considerably less time than that, as new and departing shareholders and new and discontinued business activities continually mandate new corporate entities to re-define the business relationship.
Private vs. Public Ownership
Basically, corporations distinguish ownership from management and control. Corporations permit widespread ownership, with management hired by and serving at the pleasure of the shareholders. This authority is expressed on behalf of the shareholders by the Directors, who are the annually-elected representatives of the voting shareholders of the corporation.
In small private corporations, these separate but important distinctions are blurred because it is common for the shareholder, director and general manager to be one in the same person.
The vast majority of corporations are privately owned. They generally rely on their shareholders, banks, and trade creditors for financing.
Larger corporations usually require capital in such quantity that is either too expensive, or too impractical, to obtain from banks or private lenders. As a consequence, they seek capital by selling shares on a public stock exchange, and, in so doing, become "public" corporations.
In public corporations, the distinction between management, directors, and shareholders is usually quite clear. The shareholders have the right to attend an annual general meeting. The purpose of that meeting is to review the financial statements, appoint auditors, elect directors, and otherwise ratify management's decisions over the past year.
There are many factors to be considered in deciding whether or not to take a corporation public. Usually, the prime motivators for going public are access to large amounts of relatively low-cost capital, and the ability to easily convert shares to cash through sale on the open market.
It costs considerably more to operate as a public corporation than a private one, owing mostly to the compliance duty imposed by various securities laws. These laws are designed to protect public investors by ensuring there is enough reliable information available in the marketplace to make prudent investment decisions.
Regulatory Environment
Corporations are treated as separate entities for income tax purposes. While their income for tax purposes is calculated in much the same manner as for unincorporated individuals, the actual taxes which corporations must pay are completely different. In addition to income tax, corporations may also face various provincial capital taxes, which are based on invested capital, rather than income. British Columbia’s capital tax was repealed some years ago.
Corporations must have a full set of financial statements prepared annually, as at their fiscal year-end. These financial statements, or electronic versions thereof, form the basis for the corporate income tax return.
Corporations must file an annual report to the relevant provincial jurisdiction. In B.C., failure to do this for three consecutive years can result in the corporation being struck from the corporate register, which essentially means the corporation ceases to exist, and therefore the limited liability protection of the corporation is lost. Further, the consequences of a corporation with assets being struck from the register is that, technically, a deemed dividend on wind up will have occurred, with usually catastrophic taxes the result.
Sometimes sheer inadvertence or neglect causes the charter to be struck. Such situations are usually rectifiable, but at considerable cost - in fees and penalties, and for legal assistance.
How Do Corporations Get Started?
Many corporations are conceived in an accountant's office, sometimes before and sometimes after the actual business to be incorporated has been up and running. Entrepreneurs are often keen to start business activity, waiting for the deal to "gel" before determining whether the proposed venture has economic potential, or, sometimes, before other shareholders can be brought in.
A Chartered Accountant is called in to help decide on the most appropriate business structure in the circumstances. Assuming the decision is to incorporate, usually a lawyer then gets involved: the lawyer makes application for an incorporation certificate from the Company Office of the particular province in which the business is to be operated.
The lawyer needs to work in conjunction with the C.A. in order to design the articles of the corporation, which are the rules under which the management of the company must run the business on behalf of the shareholders. The articles also contain rules regarding the relationship between shareholders and govern such matters as making new shareholders, dealing with departing shareholders, determining management authority and specifying dividend, participation, and voting rights between share classes.
Another decision made at this stage is the name of the corporation. The Company Office has guidelines on this - and if they do not approve a selected name, the onus is on the founding shareholders to select another one that is acceptable. Each business must make the fact of its incorporated status as obvious as possible in the circumstances. Consequently, each corporation will have, as an integral part of its official name, either "Inc.", "Incorporated", "Ltd.", "Limited", "Corp.", or "Corporation". Most of our clients choose either "Inc." or "Ltd." to save space on the letterhead.
Many private corporations prefer simply to remain a “numbered” company (that number being the next sequential assigned number in the provincial corporate registry).It is possible to reserve a trade name which is not necessarily the same as the official name of the corporation that operates the business. For example, "K & G's Fried Chicken" might be the business operated by "Loca Enterprises Ltd." Most corporations operate businesses whose name is exactly the same as their corporate name, however.
Some corporate lawyers maintain an inventory of ready-made, numbered, corporations. The lawyer will appear as the original subscriber for shares, as the director and president of the company. He sells his shares in this "numbered" corporation to the entrepreneur, usually also arranging for a change of corporate name at that time.The shareholders of the newly-formed corporation then inject capital into the entity by subscribing for new shares in, or making loans to, the corporation. This is usually done in the form of cash, but the capital can also comprise business assets of an existing proprietorship or partnership.
Caution should be exercised whenever non-cash assets are contributed to a corporation controlled by the transferor, as under Canadian tax law that triggers a deemed realization of the asset at its current fair market value. Gains can be inadvertently triggered in that process, and to avoid this, it is standard practice to carefully control the transaction, and, where appropriate, to file a “Section 85 election” with the Canada Revenue Agency to avoid this deemed gain. When properly filed, the corporation adopts the cost base selected in the election, and thus any latent gain is transferred to the corporation, where it may be realized, and taxed, at some future date.
Corporations often generate a need for additional capital with which to operate their businesses - this can take the form of additional loans from shareholders, from banks, or from ordinary trade creditors who supply goods and services to the business and grant deferred payment privileges. The funds thus generated are generally invested into plant and equipment, inventory, and whatever other assets that are necessary to generate sales revenue.
What Kind of Activity Can be Incorporated?
Under the general rules of commerce and the various laws enacted through the years (which are usually the jurisdiction of the provincial government to enforce), virtually any economic activity imaginable can be incorporated - even employment activity.
Members of certain professions such as doctors and lawyers were, for years, prevented from incorporating due to rules laid down by their respective governing bodies. Generally, throughout Canada those restrictions no longer apply, but there remain many economic sectors (real estate and financial brokerage, for instance) where the attributes of entrepreneurship and risk usually exist, but there is no opportunity to incorporate due to overriding regulatory rules.
For income tax purposes, the federal government has seen fit to discriminate between various types of activities conducted by corporations. The result is that some types of activity may be best not incorporated.For example, employment activity generally should not be incorporated. Employees who incorporate themselves will find that the income tax rate applicable to the income earned by the corporation is prohibitively high - the Canada Revenue Agency seeks to discourage employees from incorporating.
Earning investment income in a corporation may be tax-neutral or undesirable also, again due to the tax rates applied to such income within a corporation. Much depends here on the nature and extent of the shareholders of the corporation that has investment income.Generally, most of our clients will be attracted to incorporate to achieve limited liability, and to enjoy the preferential tax rate applied to the active business income of Canadian-controlled private enterprises. "Active business income" covers a huge range of possible economic activity, and has generally been defined the Courts over the years as just about any type of activity that a corporation might undertake.
Wishing to discriminate to a finer degree than that, the Canada Revenue Agency has, in response to these Court decisions, chosen to "carve out" particular types of business income or special treatment, leaving "active business income" as, basically, a default category.While the categorization of some types of relatively passive enterprises might pose a challenge, in general what the average man in the street would consider an active business is likely to qualify as such for income tax purposes.
"Canadian controlled" generally means that 50% or more of the shareholders of the corporation having voting rights are residents of Canada for income tax purposes (and thus declare their worldwide income to Canada annually, on their income tax returns). If the shareholder of one corporation turns out to be a corporation itself, then the ownership structure is searched on upwards to assess whether or not there is a requisite percentage of Canadian individuals "in control".
Note that citizenship status is not relevant. Thus, it is possible for a non-Canadian citizen to own and control a CCPC, assuming that person personally files a resident-based tax return.
How Many Ways to Operate a Business Are There?
Individuals operating an unincorporated business are called sole proprietors. No special applications or other paperwork (except, perhaps, for a civic business licence) is required before commencing a sole proprietorship.
Sole proprietors compute their net business income (revenues less deductible expenses) on a fiscal year basis (this can be any date, so long as it is not more than 53 weeks from the commencement of the business). This "net income" is reported on the personal income tax return of the proprietor in the calendar year tax return in which the fiscal year of the proprietorship ends. Since 1995, Canadian tax law has been amended to mandate a calendar year as the fiscal period for all unincorporated businesses. Income taxes at the rates applicable to individuals would then apply to the net business income, much the same as it would if the income had been, say, from a salary reported on a T-4 slip.
Individuals who operate a business jointly with other individuals usually do so through a partnership. A partnership is not recognized as a separate entity under income tax law, but it computes its net income from business as if it was a separate entity. Each individual who is a partner reports his or her share of the partnership net income on their personal income tax return for the calendar year in which the partnership's fiscal period ends - the same as for sole proprietors.
Sometimes, businesses are operated between individuals as joint ventures or cost sharing arrangements, rather than partnerships. Joint ventures are not recognized as distinct entities under income tax law; neither do they calculate their income as if they were. Rather, each venturer in the business computes his or her share of income independently, according to each venturer's selected fiscal year. Joint ventures are most common in the real estate sector.
Trusts can, in theory, also operate businesses. Indeed, they were the dominant structure for operating businesses in the last century. However, in comparison to a corporation, they are relatively cumbersome, and the tax rates available to trusts are not attractive. They are tremendously valuable, however, for managing capital.
Changing from Unincorporated Status to Incorporated, and Vice-Versa
Unincorporated to Incorporated:
This is a relatively common occurrence amongst our clientele, and relatively easy to accomplish.
Often, a business starts out as a sole proprietorship. If there are net business losses generated by the business in its early years, then these losses are available to offset income which may have been earned by the proprietor from some other source, such as employment.
However, once a business reaches a sufficient level of profitability, or the need for limited liability becomes significant, the proprietor usually wishes to incorporate the business.This is accomplished by first having a corporate entity created, and then selling the existing assets of the business to the new corporation. If this sale occurs relatively soon after the business began, there are usually no income tax implications in so doing. However, if the business has operated for some time and has been profitable, it is possible that a sale of assets at fair market value would result in taxable gains being realized by the vending proprietor.
To prevent this, the Income Tax Act provides a special election which permits the proprietor to alter the sales proceeds to suit his particular tax planning requirements. The corporation then assumes the assets at the cost base relating to the elected value.
However, incorporating an existing business can result in unnecessary double taxation in the area of sales and property transfer taxes. As a consequence, if a venture offers any reasonable hope of immediate profitability, the business is incorporated at the outset.
Incorporated to Unincorporated:
This transformation usually exists only in theory - once incorporated, a business stays that way until it either fails, or the owners retire and the business is wound up (although corporations can merge with other corporations in various ways to effect a change of ownership).
In a wind-up, all assets of the corporation are deemed to be sold at their fair market value. If that results in gains being recognized, then the corporation has one final taxable event to report, and the remaining assets are delivered to the shareholders, pro-rata according to their percentage interest in the corporation and the rights of the shares they owned.
There are no tax-free mechanisms to deliver corporate assets to individual shareholders. On the contrary, there are numerous penalty provisions in the income tax law designed to strongly discourage shareholders from appropriating corporate assets for their own use.
Income Tax Rate and Income Splitting Advantages:
The principal income tax motivation for incorporation in Canada centres on the small business deduction, which is a significant corporate income tax rate reduction granted by the federal and provincial governments to encourage capital growth in corporations.
The general tax rate for corporations in B.C. stands at around 35.62% in 2006. Contrast that with the rate applied to the active business income of qualifying small business corporations: only 17.62%. This rate compares favourably with the top marginal rate of personal income tax, which in B.C. in 2006 stands at 43.7%.
The key challenge is this: the corporate rate of tax can apply only to net business income retained by the corporation - it cannot apply to the portion of the corporation's income drawn out by the owners as salary. If all of the corporation's net cash flow is required for the owners' personal living needs, then the shareholder's higher personal income tax rates will apply to the income. That is generally true whether the shareholder takes all of the corporate earnings out directly, as a salary, or indirectly, by letting the corporation pay tax initially, and then distributing the remaining corporate surplus to the shareholder as a dividend (although periodic fluctuations in tax rates can create biases towards one form of income extraction as against another).
The small business tax rate can generally only be practically exploited in the following situations:
1. The business generates income in excess of the personal living requirements of the shareholders, and thus surplus funds can be built up within the corporation or a holding corporation. The big difference in tax rates encourages much more rapid accumulations of investment capital.
2. The corporation has debts owing to third parties, such as banks, which require repayment - the corporation uses after-tax earnings to reduce debt, and, with its much lower tax rate, has considerably more after-tax cash to reduce debt than would the individual shareholder, if the debt had been owed by him personally.
3. The controlling shareholder of the business is in position to re-direct some of the after-tax corporate earnings (dividends) to someone else in his or her family. Sometimes this is done by paying dividends directly to another family member who is a shareholder; but more often, and more prudently, this is accomplished by paying dividends to a family trust, which, in turn, allocates the dividends to the beneficiaries of the trust, as directed by the trustee. The effect of the dividend tax credit, when applied to the dividend income allocated to beneficiaries which might have little if any other income, is to eliminate taxes entirely on dividends as high as $30,000 per year. Shareholders who are in the fortunate position of utilizing dividend-splitting mechanisms such as this can find their overall after-tax cash flow increase, because the family trust can assume some of the disbursement obligations for household living expenses formerly assumed by the principal shareholder. The result is faster growth in wealth for the family as a whole.
Note that children under 18 years of age are ineligible for the tax result illustrated, due to the enactment of the “kiddie tax” several years ago. Strategies to counter this tax exist, but are outside the scope of this summary.
Estate Planning Advantages
Under Canadian tax law, there is no estate tax per se, but we have a reasonably close facsimile: a deemed sale of all assets owned, at full market value, on the date of death. The result of that deemed sale is that capital gains which have accrued over a lifetime become realized, and taxable, in the taxpayer's final tax return.
For the founding shareholders of corporations, this can mean that the shares they subscribed for many years earlier, for simply a nominal sum, would be deemed to be sold on death for perhaps a very substantial value, resulting in capital gains which may be in excess of their remaining available lifetime capital gains deduction. In some cases, the tax bill which results can be so large that some or all of the deceased's assets must be sold in order to pay the tax.
To avoid or minimize the impact of this problem, tax planners have exploited corporations extensively. The reason: corporations do not “die”.
One use of corporations in estate planning is to "freeze" the estate of an individual many years prior to death. The shareholder simply exchanges (on a tax-free basis) the shares he or she owns now for a new, special kind of preferred share with particular characteristics, the most important of which is that they do not increase in value in the future. This event then gives the next generation of the family an opportunity to subscribe for common shares in the corporation, which hopefully will grow in value. The value accretion is thus effectively shifted from one generation to the next.
The Canada Revenue Agency has, for many years, accepted the premise that the shares subscribed for by the next generation for a nominal sum are indeed worth only a nominal amount. This position makes many estate freezes possible, even though it is arguable that a $10.00 common share that grows in value enormously from the date of issue (due to the fact that it is connected to an operating, and very successful, business) is, factually, worth considerably more than $10.00. It is possible that the income tax environment with respect to this concept may change, but there appears to be little likelihood of it.
With the capital gain arising on death now effectively locked-in by virtue of the freeze transaction, it is often possible to purchase life insurance, or otherwise accumulate savings of sufficient amount, to cover the taxes on death without forcing the liquidation of the corporation's assets.
The same technique can be applied to assets held currently outside a corporation. By utilizing special income tax elections, the assets can be sold to a corporation, with the vendor taking back fixed-value preferred shares in exchange. Again, the future increase in the value of the assets would accrue to the common shareholders of the corporation, which are usually the next generation of a family.
Consequence of Business Failure if Incorporated
Obviously, at the outset, everyone has great hopes for a new venture. However, the statistics show that many new ventures fail - especially in their first 5 years.
If the venture was incorporated, then the consequences to the shareholders of failure will depend on the extent of their personal investment of funds in the corporation, whether creditors of the corporation remain unpaid, and the identity of those creditors.
Certainly, if the creditors possessed the personal guarantees of the shareholders, the demise of the corporation would simply lead to a collection action brought against them, personally. Similarly, if the creditor is Revenue Canada, and the taxes owed are employee withholdings or GST, the directors of the corporation would be personally liable for any shortfall.
The corporate creditors who are unsecured, however, would generally suffer a loss which could not be recovered from the shareholders. This can be a very galling experience for such creditors, particularly in situation where it is known that the shareholders of the corporation are, and will remain, reasonably wealthy individuals. Many shareholders of bankrupt corporations drive very nice automobiles, and live in very nice homes. Regardless, it has been generally accepted that the occasional perceived “unjust” result is more than compensated for by the economic growth and general benefit to society that limited liability can offer to budding entrepreneurs. Without liability limitation, it is likely that many successful ventures would never have gotten off the ground.
Shareholders of corporations which have failed often suffer personal losses. This can result from the loss of their investment in the shares and debt of the corporation, and, possibly, from guarantees that they have made to certain creditors of the corporation.
In this event, assuming the corporation was trying to run an "active" business, the Canada Revenue Agency permits the shareholder to deduct one half of the total loss against any other income of the shareholder. Doing so often results in a recovery of taxes paid in the current year, on other income. Sometimes, the business loss is so large that the shareholder suffers an overall loss in the year, taking into account any and all positive sources of income. In that case, a carryback of the resulting loss to a prior tax year is possible (limited to the prior three years). This is useful, as without this privilege the loss would in almost all cases be considered a capital loss, which can only be utilized against capital gains - which are fairly rare items of income for most taxpayers.
In particularly disastrous loss situations, the individual shareholder might have losses that overwhelm his or her net income in all of the prior 3 years - in such a case, there is provision for a carryforward of the loss for up to 10 years.
This Guide was developed in response to client requests for a convenient summary of some of the more important issues relevant to an incorporation decision. As Chartered Accountants, Lohn Caulder LLP can advise as to the income tax and practical business advantages to incorporation. However, the assistance of competent legal counsel is also important. Since every individual's particular needs and circumstances differ, this Guide cannot be used as a substitute for proper professional advice.