Tax Advantages of Alberta Corporations
In this section you will learn more about Alberta corporations. Incorporating a corporation in Alberta creates a legal ‘person’ that’s separate and distinct from its individual owners.
Aside from limited liability, possible tax advantages are the most common reason why people want to set up corporations for their business activities. That’s because of a tax benefit available to small corporations, called the small-business deduction, that the federal government introduced in 1971 to encourage the development and growth of small businesses. Alberta, which also taxes the income of small corporations, offers a parallel benefit.
The small-business deduction applies to the first $400,000 of active business income that each small, privately owned incorporated business earns each year. Active business income is income earned from the corporation’s normal activities, but does not include income from investments. The effect of the combined federal and Alberta deductions is that small-business corporations pay tax at a rate of 14 percent on the first $400,000 of active business income.
Will you pay less tax?
If your business earns less than $400,000 and your corporation can pay tax at a rate of only 14 percent, who wouldn’t incorporate? But remember who is paying the tax — your corporation; and remember where the leftover money is — in the corporation. The problem now is how you get it out and into your pocket, and what happens from a tax point of view when you do.
Once again, let’s take the example of Mary and Sally. They can take dollars out of their corporation by paying themselves a fair and reasonable salary for the work they do for the corporation, or by taking dividends on their shares, or a combination of both.
If they take a salary, that amount becomes a deduction the corporation can claim, but that amount is income in Sally’s and Mary’s hands. In fact, the corporation must issue a T4 slip to each of them, and they must declare that amount on their own personal tax return each year. Net result? No savings. If they take dividends, the same result applies. No tax savings. There used to be savings if money was taken out as dividends, but the government has been working hard to tighten up the rules over the past few years in order to eliminate that. So incorporation may not result in a tax saving to Mary and Sally
Can you defer tax?
If your corporation is earning more money than you need to live on, and you can afford to leave after-tax income in the company, then you will see a savings, at least until you need to take that money out for yourself. This tax-planning strategy is called tax deferral. The money you leave in the company is taxed at the small-business rate, and the next level of tax (the tax you would pay on it personally if you took it out of the business) is deferred, or delayed, until that money is actually paid out to you as salary or dividends. This strategy is useful if your corporation’s income fluctuates from year to year and you want to even out the flow to yourself, and if you can afford to live without any money from the corporation from time to time.
Another deferral strategy available to corporations involves declaring a bonus, which works like this. Let’s say Sally and Mary’s corporation had a good year in 2000 and earned more than $400,000 in active business income. The company can declare a bonus payable to them in the amount of the excess over $400,000 as long as that amount is reasonable. Then the company can deduct that bonus from its earnings for the year 2000, which brings its active business income down to the 14 percent tax level. Of course, that bonus has to be paid to Sally and Mary, and in fact the company can then wait up to 180 days after the end of the year 2000 to pay them. As a result, the bonus is not taxable to them until 2001. By adopting this strategy, Sally and Mary have delayed paying tax on the bonus amount into the next tax year. Whether or not this is a benefit to them depends on their other sources of income for 2001, including any more money they take out of the corporation during that year.
Can you split tax?
Both of these tax-deferral strategies involve splitting income between two taxable entities — you and your corporation — to get the lowest rate. There are other tax-splitting devices you may be able to use with your corporation, and the most common of these is to split income between family members. If you have a spouse or children who are in lower tax brackets than you are, you can arrange to have your corporation pay dividends to them. Of course, if they are working for the corporation, the corporation can pay them fair and reasonable wages for the work they do.
Corporations can be used to cap the value of a shareholder’s interest, which in turn caps the amount that has to be declared for tax purposes when that shareholder dies. The most common strategy for doing this is called an estate freeze, and it works like this. Let’s say Sally and Mary’s business flourishes as an unincorporated company, and after only a few years they are offered a half-million dollars for it. They decline to sell, but decide for estate-planning purposes to incorporate their business. They transfer their business to this newly created corporation and take back a special class of shares, called preferred shares, which have a fixed value of $250,000 each. They also set up the normal kind of shares, called common shares, the value of which will grow as the corporation grows. If Mary and Sally did not also own the common shares, then at their deaths, the value of their interest in the corporation would be frozen at the value of the preferred shares, which is $250,000. There are many variations on this approach, and Mary and Sally would have to take a number of factors into consideration before doing this, all of which are outside the scope of this discussion. They should consult a lawyer or an accountant, or both.
Shared from the Book: Incorporation and Business Guide for Alberta, Tom Carter.