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Certain tax and legal principles for corporations illustrate the advantages and responsibilities of operating a full-blown corporation. The biggest companies are listed on the various stock exchanges and thus referred to as publicly-offered companies. All companies are legal entities with limited liability. Owner/shareholders are generally paid on the basis of a mixture of salary and dividends depending on what steps need be taken to minimize corporate taxes as well as personal taxes.
For small businesses which incorporate, the most favorable status is to qualify as a Canadian Controlled Private Corporation (CCPC). These private corporations must be at least 51% Canadian-owned and “active” in offering their product or service to the general public. Furthermore, the corporations 90% of its assets must be used in the “active” business in Canada. If you are going to build and sell new homes, you are active but all income is tax fully as revenue. Active CCPCs get tax reductions and owners of shares of such companies may, under special capital gains rules, exempt up to $892,218 of gain on the sale of their common shares for sales after January 1, 2021. Corporations are treated as “active” when they deal with the public no matter if they have only one officer/director/shareholder.
A general rule is that it is a mistake to incorporate to hold investment properties to generate rent and then later sell at a profit. This would include single-family homes, condominiums, duplexes, 4-plexes or even small apartments up to 30 or 40 units. These properties should be bought individually, jointly with a spouse or personally with a group of investors, in each investors personal name in a partnership arrangement. You should then take the precaution of paying several hundred dollars in insurance premiums each year to get extra liability insurance for slip-and-fall actions and wrongful death in the event tenants die in a fire. This will protect you and the assets of the company as the insurer will cover the cost of lawsuits. The reason for avoiding incorporation is that when the primary source of income for a corporation is rental income, the company does not qualify as an active corporation and will enjoy none of the benefits of a CCPC. In fact, rental income is treated as passive income along with interest and dividend income and these forms of income are taxed at a punitive rate under the Income Tax Act at about 50%.
When a company owns real estate and its primary source of income is rent, it will be deemed to be a property management company” and thus active and enjoy all of the benefits of a CCPC, ONLY IF it has at least six full-time employees. (ITA subsection 125(7) (e)). You would have to buy a 500-unit apartment building or up to a $50 million commercial building for you to need the services of six employees. We call this the five janitors plus a property manager profile. So, DO NOT INCORPORATE to hold one or several rental properties. You will pay about 50% corporate taxes PLUS at least 15% more on the after-tax dollars issued to shareholders as dividends. This creates combined corporate and personal taxes of over 60% compared to the highest personal tax rate of 53.5%. It is a tax and financial disaster.
There is more flexibility for income-splitting and deducting expenses with a corporation. To split income, spouses and children may be paid wages as employees and/or directors. With many small companies, spouses are set up with 50/50 ownership of the common shares so that EACH will qualify for the $835,714 Lifetime Capital Gains Exemption on the sale of these common shares prior to January 1, 2018. If they are not shareholders, spouses and children must be paid by the corporation on a Fair Market Value basis for services rendered. In Ontario, individuals 18 and over may operate as directors of a corporation. The owners of highly profitable private companies may thus make their children 18 and over directors of the company, and, for instance, pay them $10,000 a year in directors fees. Nice money to help with university costs. Make sure to hold at least one annual directors meeting so that the directors are seen as active in company affairs. An annual directors meeting is often held solely to approve the annual Financial Statement and the Federal and Ontario corporate tax filings. Once done, someone moves to close the meeting.
However, the current Federal Government has proposed changes to tax laws that include limiting CCPC owners from income splitting to spouses and children over 18 years of age. Currently, the owner of a corporation can “sprinkle” income to their family by way of dividends, thus reducing the amount of personal tax payable for the business owner. However, under the new rules, spouses and children would be required to pass a “reasonableness test”, meaning they are actively contributing to the business. As such, any amounts received by family members must be considered reasonable for the work they perform.
Income sprinkling – sometimes referred to as “income splitting” is a strategy that can be used by high-income owners of private corporations to divert their income to family members with lower personal tax rates.
Under the current income tax rules, the TOSI (tax on split income) applies the highest marginal tax rate (currently 33%) to “split income” of an individual under the age of 18. In general, an individual’s split income includes certain taxable dividends, taxable capital gains and income from partnerships or trusts.
Corporations are separate legal entities with limited liability. Creditors are restricted to seizing corporate assets although major creditors will frequently require that officers/directors provide personal guarantees on corporate debt. Otherwise, shareholders, officers or directors are not personally liable for corporate debts unless they engage in criminal conduct or are grossly negligent. Directors may be held liable by the Canada Revenue Agency for un-remitted payroll deductions and any GST balances owing. The Ontario government will also hold them liable for any PST balances owing. Payroll, GST and PST are monies which are considered to be trust amounts held for the government. If a director has no knowledge of non-remittances and is not involved in day-to-day activities, a ‘non-active director’ defense may be raised if the Directors are deemed to be liable for such amounts. Insurance protection should be provided for directors and to protect the value of a successful corporation.
The goal is to minimize taxes getting money out of a corporation. Balancing salary with dividends is frequently the optimal approach. Taxable benefits result if you get a company car or receive interest-free loans to purchase a home or shares in the corporation. These arrangements are advantageous. You can defer personal taxes on bonuses paid to you by a corporation. Corporate bonuses may be deducted immediately by the corporation and paid to the recipient within 6 months. When a company has a year-end in the last 6 months of a year, it can declare immediately-deductible bonuses and pay them in the next calendar year to the recipient. This reduces corporate tax and defers personal taxes. Dividends from any Canadian corporation are taxed preferentially since the Dividend Tax Credit partially offsets corporate taxes paid. A spouse receiving only Canadian dividends, would pay no personal taxes on about the first $30,000.
For active CCPCs, the Small Business Deduction (SBD) will result in a combined Federal/Ontario corporate tax rate in 2021 corporate filings of as low as 12.2% on the first $500,000 of corporate taxable income and any additional income would be taxed at the combined rate of about 19.3%. Companies with pre-tax profits in excess of $500,000 should pay salaries to the shareholders to reduce taxable income down to that $500,000 threshold. This is smart since you will pay over 26% tax on taxable income over the threshold plus another 15% plus in personal taxes on dividends paid with the after-tax dollars. The taxes paid will thus EXCEED the highest personal tax rate of 53.5%. So, pre-tax income over the $500,000 level will be taxed at a lower rate in personal tax returns if paid out in the way of salaries or bonuses.
Under the “Rule of Association”, the SBD must be apportioned among “associated corporations” where there is common ownership. The test is “control” and Revenue Canada will decide the degree of ownership that gives de facto control. Check share ownership of investors. Spouses owning different corporations will be treated as associated.
You can do things to increase the value of common shares of active CCPCs qualify, on sale, for a capital gains exemption of up to $$892,218 per taxpayer under the Lifetime Capital Gains Exemption (LCGE). Make shares more `saleable’ by: adding employees to increase revenues and to provide continuity; selling shares tax-free under the LCGE to employees to give them equity; and, using corporate after-tax dollars to build up ‘hard’ assets. You can use after-tax dollars accumulated by the corporation to buy a condominium suite or building from which to operate your business. This gives the company a real estate asset increasing the book value of a company.
INCORPORATION FOR REAL ESTATE AGENTS
On October 1st, 2020, the Provincial government brought forward Ontario’s new rules for forming Personal Real Estate Corporation (PREC). In reality, this means real estate agents can now start earning their commission income through their PREC. Just like dentists, lawyers, and other professionals PREC allows real estate professionals to access the business advantages of incorporation, including tax and income planning benefits.
To be eligible for forming a PREC, the controlling registrant must be an existing member of the Real Estate Council of Ontario (RECO). It’s important to note that a PREC is not a professional corporation as considered under the Business Corporation Act and differs from traditional private corporations in the following ways:
- Only real estate agents can be voting shareholders of a PREC
- Either the real estate agent or the PREC or both are subject to the oversight and regulatory powers of RECO
- A PREC does not limit professional liability
Real estate agents will be able to significantly reduce their taxes by using a corporation. For example te first $500,000 of net income in an Ontario corporation is taxed at a corporate tax rate if 12.2% whereas some realtors are probably paying a personal tax rate of 53.5% on any income earned over $220,000. With PREC, the tax savings can amount of up to 41.3% a year.