5 common tax mistakes

Entrepreneurs are often so focused on what they do best that they fail to adequately

plan how to structure the business itself. In particular, failing to make use of a corporation and to monitor its operation can lead to significant forgone benefits and potential liabilities.

This list covers five of the most important tax and estate issues most entrepreneurs may face.

1. Failure to incorporate slows business growth

If your client runs a sole proprietorship, she will be personally taxed on the income, ranging from 39% to over 50% at top bracket, depending on province. After tax, this means the amount available for reinvestment in the business annually is almost half or less than what was originally earned.

By comparison, a small business corporation is entitled to a flat rate of tax below 20% on its first $500,000 of active business income. (The provincial tax threshold is only $400,000 in Manitoba and Nova Scotia.)

Read: Ontario, Quebec fall short on small biz-friendly taxes

When the accumulated income (the retained earnings) is reinvested in the business, each dollar the business earns will generate in excess of 80 cents in useable capital.

2. Failure to incorporate means losing tax-free capital gains value

A business earns income from year-to-year, and it also grows in value itself to the extent that earnings are retained within it. If the business is run as a sole proprietorship, upon sale the owner will have to pay tax on the growth in the business’s value, which is the capital gain.

By comparison, every person is entitled to a $750,000 exemption from tax on the capital gains associated with qualifying small business corporation shares. This amount will rise to $800,000 in 2014, and be indexed annually thereafter.

If the same business is run as a corporation under these rules, the owner can save about $150,000 (or more) in tax on the disposition or sale, including a deemed disposition on death.

3. Failure to incorporate means exposure to creditors

Launching a business is often a risky endeavour in at least two respects. It exposes the client to:

• banking and trade creditors who have provided financial backing to the enterprise;
• liability claims under contract and tort (e.g., negligence) in the normal course of business operations.

If a person runs a business as a sole proprietor, both these liabilities will be imposed directly upon that person, and his assets will be subject to claim by such creditors.

Read: 5 tips for clients with new businesses

A corporation is a separate legal entity from the shareholders who own it, so liabilities that arise within the corporation do not flow up to the owners of the corporation. Unless the shareholder has executed personal guarantees on behalf of the corporation, or has otherwise personally acted in a way to attract liability, the only personal asset at risk for the shareholder will be the investment in the corporation itself.

4. Holding investment money in a small business corporation

The small-business tax rate is only available on a corporation’s active business income—earnings generated from its actual commercial activities.

By contrast, passive income arises out of excess corporate cash being placed in portfolio investments, including bank interest, GICs or marketable securities.

Passive income is taxed at the regular corporate rate, and it is also charged an additional refundable tax that results in a total immediate tax payment close to 50%. Rather than face these complications, a shareholder may want to issue herself dividends, pay the tax on the dividend, and invest the net funds personally.

Alternatively, if the owner would prefer to defer those dividends, she should pay attention to the type of returns generated on those continuing corporate-held investments. Generally this means trying to achieve tax-deferred returns such as unrealized capital gains, or using the sheltering capacity of exempt life insurance in qualified circumstances.

5. Paying personal expenses out of a corporation

A small business owner who pays personal expenses with corporate money is in for a rude awakening. Such payments will likely be deemed as shareholder benefits and be taxed at the shareholder’s marginal tax rate.

Read: Unite business and personal goals to retire well

The proper procedure would be to issue dividends from the corporation to the owner. The net effect of the gross up and tax credit procedure is an effective tax rate about a third less at top bracket, and significantly lower at more modest bracket levels.

Doug Carroll, JD, LLM (Tax), CFP, TEP, is vice president, Tax and Estate Planning, Invesco Canada