Smoothing your Personal Income Tax Liability
One of the things I do in my spare time is volunteer as a mentor for small business start-ups in a program run by the Small Business Enterprise Centre of the Hamilton Economic Development department. We cover a wide range of topics, but one in which my advice is sought out continually is whether an entrepreneur should incorporate their small business. The correct answer is of course “it depends”. That being said, I will admit to being an unabashed proponent of incorporation in most circumstances where the entrepreneur has made a serious commitment to starting and growing their business, and is not just “testing the waters”.
This is the first in a series of blogs I expect to write on this topic over the next year. As we wait expectantly for the outcome of the current tax reforms aimed at small business, I will keep to issues that will not be impacted by the proposed legislation.
Rather than spewing a laundry list of pros and cons, what I intend to do over this series of blogs is cover several very specific benefits and/or pitfalls related to incorporation. Although many of these issues will not apply to all businesses, the impact on businesses to which they do apply can be significant.
One of the risks of being an entrepreneur is that your income is uncertain, and in many businesses, earnings can be volatile from year to year. If you are an unincorporated sole proprietorship, what this means is that one year you may be paying taxes at very high marginal rates, and the next at relatively low rates – you have very little control over managing your taxable income. For entrepreneurs in this situation, the incremental costs associated with incorporation along with increased annual professional fees (which are generally the biggest downsides of incorporating) can be more than offset by savings in income taxes.
To illustrate this I will provide an example – although the example has been simplified for this purpose, it is based on the income of an actual client.
Unincorporated Business: (taxes are based on Ontario 2017 rates)
Year 1: Taxable income – $20,000 / income tax payable – $1,000
Year 2: Taxable income – $100,000 / income tax payable – $24,000
Year 3: Taxable income – $60,000 / income tax payable – $11,000
Year 4: Taxable income – $180,000 / income tax payable – $60,000
TOTAL INCOME TAX OVER FOUR YEARS – $96,000
By incorporating this business, the strategy is to smooth out the income so that the individual does not pay any taxes at higher marginal rates. In this case, we will assume that the taxpayer needs to take out 100% of earnings for personal use over the first four years (there will be a future blog post on additional tax advantages available if funds are not needed personally and can be left in the company). To achieve this, the corporation will declare a salary of $90,000 per year. To the extent that the corporation does not have the cash to pay this salary in certain years, it will issue a short-term note payable.
I have manipulated the numbers somewhat so that the $90k works out be exactly 25% of the total earnings over four years, but the amount is not an arbitrary figure chosen in hindsight because future revenues are known. The amount is chosen at the end of year one, specifically because there is a large jump in marginal tax rates just above that figure. In implementing this strategy you do want to be fairly confident that the business will generate enough income to cover the salary within a reasonable time horizon so that you are nor prepaying a lot of tax. If you were less confident about future income levels by the end of year one, you might want to reduce the salary declared to say $60,000. The long term tax savings would be reduced somewhat, but you would have prepaid less tax and reduced your risk.
Back to the $90k figure however, the personal taxes paid would be $20,000 per year. Corporate taxes would be nil, since over four years the corporation would have no income after the payment of salary.
TOTAL INCOME TAX OVER FOUR YEARS – $80,000 Savings of $16,000 over four years.
Keep in mind, this strategy addresses two specific circumstances:
1. You are a start-up business with increasing revenues; or
2. You have significant volatility in earnings (enough that you will be jumping between marginal tax brackets.
If you have a mature business with little earnings volatility, stay tuned for more strategies in future posts!
Finally, in the current climate of politicized tax commentary, I would like to point out that this type of strategy is not an unfair benefit that incorporated business owners have over average taxpayers earning a salary. Rather it is a rectification of the higher taxes that an entrepreneur is at risk of paying due to the volatility of their earnings.