Tips and traps for small business owners

We all have great business ideas, and they only seem to grow as we age. For example, when we start having kids, we think ‘why don’t they have better shoes for kids who can’t walk’ (thank you Robeez). Or as our kids age, we think ‘why can’t my kids decorate their Crocs’ (kudos to the lady who made millions with her Crocs charms…Jibbitz). Let’s face it, we ladies are brilliantly innovative gals! But what stops many of us from even pursuing the first step to entrepreneurship is all the start-up considerations, including those hard-to-answer questions of whether to incorporate, how best to retain earnings, and all that jazz. Frankly, it can get overwhelming. So here’s a start, thanks to our golden guy Dave C. In his plain language style that we love, he’s drilling down some of the most important issues like whether to incorporate or not and how to retain more of the money you make. You gotta love that. So get out there and get started on ‘the next big thing!’ (And tell us all about your success. Girls need to celebrate together.)

This article is designed for small business owners (from 1 to 50 employees) and contains some useful tips for you to use and potential traps to avoid.

We’ll talk both about tax and governance, but space limitations mean we can’t go into a lot of detail. If any of these situations applies to you, get more information and professional advice.

Incorporation Considerations

Many people start a small business as a sideline to their employment. In most of these cases, it is best to stay unincorporated (and operate as a sole practitioner or partnership) until the business is profitable. While your expenses exceed your income, this creates a loss that you can claim personally and decrease the tax on your other income.

You fill out a T2125 form to declare the income and add up the eligible expenses.

Once the business is profitable, you may want to incorporate. However, there is no real tax advantage to incorporation until the company is producing more profit (and cash) than you need to live on each year.

Canadian owned corporations that produce active business income (not investment income) are allowed something called the small business deduction. On the first $225,000 of profit that is left in the corporation each year, the corporation will pay tax at a rate below 19%. (This limit is going up over the next 5 years.)

This lower rate applies to any incorporated business, including professional corporations. For example, if a company will generate $200,000 of profit after all expenses (but before paying the owner a salary) and the owner only needs $100,000 of pre-tax salary to cover all personal expenses and RRSP, then it may make sense to leave the other $100,000 to be taxed as profit in the corporation. Tax on that $100,000 will be under $19,000, rather than the roughly $46,000 of tax that the owner would pay if it was paid as a bonus to the owner and taxed personally.

The profit then becomes retained earnings in the corporation, where it can be invested. Caution must be exercised here, though. Any cash reserves or investments in the company that are not required in the normal course of the active business will generate investment income that is taxed at the top corporate rate, usually in excess of 45%.

Selling shares

Another consideration is whether your plan is to sell the shares of the corporation down the road. If the company qualifies as a CCPC (Canadian controlled private corporation - roughly meaning that 90% of its assets were involved in an active business for the 2 years prior to sale), then the first $500,000 of capital gain on the sale of shares (not assets) is tax free to you.

Holding the excess investments in the company can throw it off side from these rules, and make the shares more difficult to sell. Typically, a separate investment holding company is one solution.

The earnings trap

Another concern about building retained earnings is that they can become “trapped” in the corporation. In a perfect world, this is not an issue. These funds would be used to finance your retirement down the road.

For example, if $1 million had been built up in retained earnings and invested, this money would be generating investment income (hopefully dividends which are not taxable to your corporation until paid out to you), allowing your company to pay dividends to you, the shareholder. Good planning would have the share ownership “shared” amongst your family.

If you have no other income (like salary, self-employment, pension or RRSP/RRIF income) the dividends will be taxed at a very attractive rate. If you layer them on top of RRIF withdrawals or other income totaling $100,000 per year, they could be taxed as high as 35%, still better than other forms of income.

Some business owners end up with money in their corporations that will never be used while they are alive. In this situation, purchasing a universal life insurance policy owned by the company can be a way to free up this trapped surplus.

The expense perks

Back to today, having the corporation pay all business expenses is obvious, and it even makes sense to have the business pay for non-deductible expenses, like life insurance premiums and club memberships. Although the company can’t deduct these, it is paying them with 82-cent dollars, instead of your own puny 55-cent dollars (after taxes are paid).

Stop talking to the wall: get outside help

Consider the use of outside consultants or an outside advisory board. As one business owner said to me, “It gets tiring talking to the wall,” and outsiders can give a different perspective and in many cases, experienced advice.

There is much more to talk about, like the decision between salary and dividends, paying your spouse or children, the tax treatment of gifts for employees, tax rules on automobiles and the deduction of dental and health premiums. If you would like to hear more details about any of these things, please shoot me an e-mail. I’m happy to help.

The preceding article is provided as an introduction to this topic and should not in any way be construed as a replacement for proper professional advice.

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