Incorporating a farm or small business brings its share of headaches, but for farmers paying what they think is too much income tax, incorporation deserves a serious look.
- Do you run your farm or other small business as a sole proprietorship or partnership?
- Does your total income put you in any but the lowest personal income tax bracket?
If yes, you may want to consider incorporation. The preferential tax rates available to small businesses make incorporation the single most lucrative tax advantage available to these companies.
In some cases, the income tax rates a small incorporated business would pay are less than 50% of the personal tax rates the owner would pay operating his business as a sole proprietorship.
Since 2000, the federal government has gradually reduced corporate tax rates, giving particularly favourable treatment to taxes on small business income below the increased small business limit of $300,000 for 2005.
To make things even better, most provincial governments also have reduced corporate tax rates. In addition, the provinces have increased the income thresholds to which the provincial small business tax rates apply, making more companies eligible for them.
To demonstrate the tax benefits of incorporation, say you have a business in Ontario. You operate it as a sole proprietorship and your net taxable income in 2005 totals $200,000. Assuming the business is your only source of income, your personal marginal tax rate would be 46.41%, and you would owe about $78,000 in combined federal and provincial income tax (assuming zero non-refundable tax credits and deductions).
However, if the business was incorporated, income would be taxed at only 18.62% and your total income tax owing would be about $37,000 within the corporation (assuming zero owner salaries and/or dividends paid that would attract personal income tax). That's a tax savings of $41,000 that can be deferred within the corporation.
Tax breaks aren't the only benefits of incorporating your farm or other small business. Additional pluses of the corporate business structure include:
Separating your corporate and personal assets can, to some extent, protect your personal assets from creditors should your business fail. However, many financial institutions do request a pledge against personal assets to secure business loans.
Fiscal Year Flexibility
You can choose a non-calendar fiscal year for income tax reporting if you want one that better suits your business cycles.
It may be possible to defer income by putting off payments from the company from one year to the next.
Group Insurance and Retirement Benefits
Corporations can create a registered pension plan and obtain tax-deductible group health and life insurance plans for their employees and family members.
Income Splitting Flexibility
If your spouse or children are involved in the business as employees, shareholders and/or directors, funds can be distributed to them in a number of ways. These include salaries, consulting fees, dividends, directors' fees, and even custom farming arrangements.
Additional Means of Compensation
You can take money out of the business in various forms, including rent, capital dividends, and loans. The company can even pay an owner a retiring allowance, which could be transferred to an RRSP.
Another important feature of a corporation is that it has a life of its own. The company can continue as long as the shareholders want to keep it going, long after the founding owners die.
While incorporation offers many advantages to small business owners, it's not for everyone.
The benefits diminish to the extent you must tap into earnings to cover personal and living expenses. To benefit from the corporate structure, you must leave at least some business profits in the company as retained earnings. Or you can reinvest some profits in the business or purchase other investments. If you draw too much income from the business, you'll have to pay additional personal tax on salaries or dividends.
Nor would it be wise to incorporate if you are expecting tax losses from the business. Tax losses incurred by a corporation are deductible only to the business, not to you. Since start-ups often have losses in the first few years, it's usually wise to defer incorporation until the business is profitable.
You also should be aware that incorporation means more detailed legal, financial and tax reporting, as well as increased accounting and legal costs.
Transferring assets out of a corporation can trigger high tax rates, and winding up a corporation can be quite a headache. As well, government scrutiny and regulatory compliance increase substantially.
So, even if your business is ripe for incorporation and its accompanying advantages, the decision requires much thought and careful planning with your professional advisors.