After working 60 – 70 hours a week for years, you were finally able to pay yourself a decent salary and leave a healthy portion of profit in the business for reinvestment. It’s an exciting new level for your business! You bootstrapped the startup with your personal savings and a bit of help from relatives, made a ton of mistakes, hit your stride, and now you’re reaping the rewards.
Then the tax bill came in.
For the last few years, you just took your books to an inexpensive bookkeeper who processed your tax return in record time. You figured out how to live frugally so you could take out a small salary and leave more money in the business. When you were well in the black for the second year in a row last year, you decided it was time to start paying yourself a healthy salary.
This year, after taking your books to the inexpensive bookkeeper, you were devastated by how much you owe the CRA. When you sat down across from the bookkeeper to sign the tax file, they asked why you haven’t claimed more travel expenses, or why you don’t have a medical plan set up, or why your spouse doesn’t have shares in the corporation.
You shrug. You thought you were being clever, starting up as cheaply as possible. You found a way to incorporate your business online without paying out too much.
Maybe you saved a thousand dollars in the beginning, but now you’re paying out many times that amount. The vacation fund you were building up for this year’s trip to Italy just went to the government instead.
* * *
We hear stories like this one all the time. There’s no shame in it, but it’s a painful lesson to learn the hard way.
Maybe you’re not there yet. Maybe you can learn from so many others like this and plan out your corporation before your business starts operating. If you start considering the impact of your corporate structure from the very beginning, you can save thousands on taxes and get to your vacation (or investment, or retirement) goals much quicker.
You’ve sacrificed for it. So, protect it. Keep more of it.
Accountants don’t just do taxes. They help you keep and grow the money you make. Otherwise, you either end up paying the government more than you need to or worse, you cross legal boundaries you didn’t know existed.
“It’s not about how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.”
Robert Kiyosaki is often quoted for this specifically, but the notion that you have to protect what you earn is an ancient principle. Good accountants will sit down with you and get to know you personally. You have unique goals and there are many paths to get you there. It takes specialized understanding to make sure you get there in the quickest, safest way possible.
Although you need tax planning, that’s just one important element of the bigger picture – wealth planning. Good accountants find all the pathways you’re allowed to defer taxes, income split, or achieve absolute tax savings. Then you need financial planning, which is a whole other set of expertise.
Instead of just pushing out a tax return, good accountants need to ask, “What are your plans for this year? What are your plans for the next 5, 10, 20 years?” The tax return is ‘now.’ They’re planning and structuring your business to clear a pathway for you to achieve the things you originally set out in business to attain. Financial planning puts your personal financial goals into terms that tax planning and business structuring will understand and aim for.
So, the question becomes, what’s all your sacrifice for? You’re putting in long hours and giving up family time for something. What is it? Make sure you have a plan that gets you there with as little grief as possible.
Your business structure is the foundation you build wealth on.
Ok. So, your accountant should plan out your business structure and taxes according to your personal financial goals. The first element to establish, then, is your business structure.
There are three basic business structures in Canada:
- Sole Proprietorship
How do you know which structure benefits you most? The answer is found by asking, again, what are you sacrificing for?
Do you need to be nimble, able to make decisions on the fly with less expectation that you’ll submit documents and reports to the government on a regular basis? A sole proprietorship or business partnership (unincorporated businesses) may serve you best.
The trick is, profit from unincorporated businesses show up as self-employment income on your tax return. So what? Well, if you make 30, 40, 50 thousand dollars in a year, then, compared to your old day job, you may not notice a big difference in income tax you owe. But as your business grows and as you earn more, your tax rate goes up. It won’t take long before you’re paying more tax on your business profit than an active corporation would.
Another consideration is how many people you serve and how many risks are inherent in your business? The more people you serve, the more risk that comes with your business activities, the more vulnerable you are to being sued should catastrophe hit. Incorporated businesses have some protections built in against those risks.
Finally, do you have dreams of expanding, of scaling your business to serve a national or international market? Will you need investment from other partners? Your investment partners can only own shares of an incorporated business. Most capital partners won’t even consider investing in unincorporated businesses.
So, what does it take to incorporate it? What are the benefits and drawbacks?
Set up your corporation to maximize your freedom and limit your tax burden.
Do you want to save thousands on taxes, empower your business for rapid growth, and protect your personal savings from potential lawsuits?
Then incorporation is your smartest move.
Your business is growing. You’re handling more debt (loans or credit for growth), you’re venturing into experimental phases, and your profits have thrust you into the top tax bracket. Incorporating your small business will give you access to tax relief, greater growth and investment options other than personal loans or credit, and in most cases, you’ll be personally protected from creditors or legal action should anything go wrong.
How, then, do you incorporate it?
You need a lawyer, a good accountant, and a financial planner. A financial planner helps you set personal financial goals. They work with your accountant to create a pathway to those goals. Your Lawyer creates a legal framework for your corporation that actually allows everything to work happily in the eyes of the law. Because a corporation is just a legal document. It describes who shares ownership of the company, who sits on the board of directors, and who the officers of the company are.
So once your personal financial plan and corporate structure are planned out, your lawyer makes it all real.
At this point, you do have a responsibility to provide the government with specific documents and reports on a regular basis. Your corporation is taxed as an entity separate and distinct from you and your partners, so a whole different set of taxes are filed each year, apart from your personal taxes.
But now you can take advantage of the small business corporate tax rate, which is pretty low compared to most personal tax rates. You can give your spouse or adult children an active role in the business and split the income with them. There are also many expenses that you can claim as deductions to lessen the tax load and benefit you directly.
Make smart use of your business expenses.
Which expenses can and can’t be deducted?
The short answer is, “Any reasonable current expense you paid or will have to pay to earn business income.” [from cra.gc.ca]
But of course, your definition of “reasonable” may be different from the CRA’s. So, the long answer is significantly more involved.
First, there are two types of expenses: current expenses and capital expenses. How much you can deduct for any expense in one year depends on which category the expense falls into.
You can also claim the GST/HST you paid on each expense; minus the input tax credits you would have claimed. Personal expenses cannot be deducted, but if you use the personal property for business purposes (like your house or car), then you can claim the business portion of those expenses.
See how quickly this gets complicated?
Here’s the list of expenses that you can deduct from your profit before paying taxes:
- allowance on eligible capital property
- bad debts
- business start-up costs
- business tax, fees, licenses, and dues
- capital cost allowance
- delivery, freight, and express
- fuel costs (except for motor vehicles)
- interest and bank charges
- fees, penalties, or bonuses paid for a loan
- fees deductible over five years
- fees deductible in the year incurred
- interest deductible on property no longer used for business purposes
- interest on loans made against insurance policies
- capitalizing interest
- interest related to the workspace in your home
- maintenance and repairs
- management and administration fees
- meals and entertainment (allowable part only)
- long-haul truck drivers
- extra food and beverages consumed by self-employed
- motor vehicle expenses
- legal, accounting, and other professional fees
- prepaid expenses
- office expenses
- other business expenses
- property taxes
- salaries, wages, and benefits (including employer’s contributions)
- telephone and utilities
Here’s the crazy thing, not all those expenses are fully deductible. Many of them have specific, individual rules about how and when they can be deducted. A good accountant will know all those rules and how each expense works in your unique situation. Believe it or not, there are legal ways to actually “get paid” for certain expenses you personally incur for business purposes, but your accountant needs to make sure it’s all within the rules.
It’s two or three times better when your spouse and adult children claim those expenses too. Of course, then they need to be a part of the business, but that has distinct advantages as well.
When income sprinkling is right for you.
This is where the math gets heavy. So, to spare you the agony, let’s take a broad overview of what income sprinkling is and how it could help you.
Let’s say your business is earning a tidy profit. More than enough for you to take out a healthy salary. But if you start paying yourself a lot of money, your personal tax rate can reach as high as 53%. To avoid giving more than half your income to the government, it might be time to give your spouse or adult children an active role in your business.
If you are earning a large income from your business, you can funnel some of the income to your family members who are taxed at a lower rate. The money goes to a different person but stays in the family. This is particularly useful when done with your spouse. If your adult children don’t live in your household anymore, but you still want to contribute to their success, especially if they want to work in the family business, income sprinkling is a legal way to reduce your personal tax burden.
Family members that work at least 20 hours per week in the business see the most benefit in the income they receive from the business. There are ways to split your income with children under 18, or with family members that aren’t as active in the business, but there are some extremely fine rules about who qualifies and how much tax they must pay.
All of this, from incorporating, to claiming expenses, to income sprinkling are forms of tax savings and tax deferrals. This is how a smart entrepreneur designs their lifestyle and builds their business. They structure everything so that the tax burden is as low as it can be, and they keep more of the profits. There are other ways to defer taxes too. They stray into more complicated legal and accounting principles, but let’s look at your options and who they can help.
Other smart moves to defer taxes.
Tax evasion – trying to shirk out of paying taxes – is a criminal offense.
Tax avoidance – manipulating your affairs to achieve an unfair tax advantage – can also land you in hot water.
But the government provides many avenues to delay paying tax until a future date. This is called deferring taxes. Tax will eventually have to be paid, but it allows you to put the money you saved to good use before the government takes its share.
When you defer taxes, you’re putting the money to good use in other places. Some tactics are passive, the money sits in an account earning interest. Those options are very tricky in Canada right now.
Federally, there are a lot of rules about how much of that passive income will be taxed. It’s important to know how much of your profit to put in which types of accounts.
Here are some tactics a good accountant will consider when they plan the pathways to your financial goals:
- Incorporating your business could be a form of tax deferral. If you make $250,000 in a year, your corporation is going to be taxed much less than if you personally made that money. Now you want to access the money, so you will eventually have pay yourself, which is when you will be taxed at the personal rate, but there are ways to use that $250,000 efficiently in the corporation so you realize the full benefit of that income, but pay minimal taxes.
- Income sprinkling is also a form of tax deferral. Paying your spouse for work they do in the business keeps the income in the household, but reduces the rate it’s taxed at.
- Loan your spouse some money. In specific situations, it’s possible to loan your spouse a chunk of money for investment purposes. You must charge them an interest rate, but the point is to make sure your spouse will earn more income from the investment interest than the interest they’re paying you.
- Invest in TFSA, RRSP, RESP. These kinds of accounts generate income through interest or investments but have very specific rules about how they are taxed. Each type of account lets you pull out money in specific ways without it triggering any income tax (first time home buyers, paying for tuition, etc.). This allows you to defer or even save on taxes years down the road.
- Set up an Individual Pension Plan (IPP). This is like an RRSP, but it lets your corporation contribute more money to your retirement each year. Again, there are special rules for IPPs, but you could, in theory, set up a pension for yourself as an employee of the corporation and funnel more of your income into your retirement without paying taxes on it right away.
- Have the corporation contribute to life or critical illness insurance policy on your behalf. This gets complex, but can help defer tax, divert cash from the corporation to yourself tax-free, or alleviate estate taxes at death.
See how crazy this gets? There are a lot of tactics at your disposal to keep more of your income and build wealth, but there are so many ways to get tripped up as well. When you work with a professional, mistakes are limited. But it’s not uncommon to see entrepreneurs make some big mistakes when they work on their own, thinking they’re clever because they’re “saving money.”
These mistakes will cost you more than the bill for a good accountant.
These are the most common mistakes made by entrepreneurs who bootstrapped their business and “saved” on expensive accounting fees up-front:
1. Incorporating without a lawyer and accountant working together.
It’s easy enough to go to a lawyer and get some corporate documents drafted and signed. You can even do it online. But if there isn’t a financial plan in place to guide how the lawyers structure the shares in the corporation, the corporation could have no benefit to you at all. Correcting this is costly and time-consuming
2. Putting family on the payroll after the fact, after they’ve “worked.”
Putting family on the payroll is a strategic way to save on taxes, but they must actually work for the business to qualify for the salary. If you can’t prove they put in the hours the CRA may reverse the salaries.
3. Paying dividends to children who are minors or related persons without planning.
You can technically pay dividends to minors, but the tax rules are strict and heavy. A good accountant will recognize a situation where this might be beneficial, but usually, it’s best to avoid paying dividends to your children that are still minors. A previous Ontario government introduced the Tax On Split Income rules (TOSI) to regulate “income-sprinkling” by spouses and adult children of tightly held companies. Income splitting is still possible but navigating the rules is no simple task.
One example of how to invest your profit properly.
Let’s say you have a corporation earning active income and you’re paying tax at the low rate. Now you want to invest in a rental property. How do I do this?
First, you need a down payment. If you want a $500,000 rental property, you likely need to put $100,000 down in cash. If your corporation can pay the $100,000, you’re going to get there a lot quicker than if you take the money out as a dividend or salary, pay the higher rate of tax, then pay the down payment. Your corporation is paying 14.5% tax, you’re personally paying upwards of 53% tax.
So, you’re going to find the right investment property, making sure that its cash flows positively. A good accountant will look at making it a part of your business by creating a sister corporation besides your main corporation to hold the property. Then you’ll use profit that’s left in your primary corporation (taxed at a lower rate), loan it to the sister corporation to fund the down payment of the property and make the investment from the sister corp.
You just saved a $100,000 down payment a lot quicker by not pulling that money out of the corporate group.
Because your goal was clear – to buy a rental property – your accountant was able to get you there quicker, with less tax impact. So that leaves one question that every business needs to start with…
What are your goals?
As you dive deeper into what it takes to build a business, you can see why having clearly defined ambitions is important. Your business exists to propel you towards your personal goals. If you are just in business to be your own boss and make a lot of money, then all you have is another job that wastes your time and energy (yes, being the boss is a job). But if you are in business to serve in a specific way, to intentionally make an impact on the world around you, then you can map out a clear plan along the quickest, safest path to those goals.
You need a lawyer, a financial planner, and a good accountant who understands your personal goals, where you want to be in life, and can create a tax plan to max out the benefit you glean from your business. Otherwise, you’re just submitting tax returns and missing out on a slew of benefits you have available.
What were the last few years of 60 to 70-hour weeks really for? What first motivated you to drop the day job and become your own boss? What vaulted you over the fear of uncertainty and instability?
Build from those motivations with a team of experts to take the anxiety out of finances and achieve total profit potential in all your business ventures.
Our team of highly qualified accountants can help you get on track to achieving your personal and business goals. Email firstname.lastname@example.org or phone (289) 813-0097 ext. 101 to see if your business is set up for success.