By: Jim Stathakos CPA and Besse Vergados BA (Honours)
Are you thinking about starting a new business?
Let us explore the income tax advantages of incorporating a new business versus operating it as a sole proprietor or partnership.
Tax advantages of incorporating a business:
Incorporation allows the business income earned in Canada to be taxed at lower corporate rates initially. This is primarily because of the Small Business Deduction, which is available to Canadian Controlled Private Corporations (CCPC), earning active business income.
Income from investments and income from a Personal Service Business do not qualify. Per the Canada Revenue Agency (CRA), a Personal Services Business (PSB) is a corporation set up to provide services that would normally be performed by an employee.
The combined Federal and Province of Ontario tax rate is 26.5%. Effective July 2026, for CCPC’s the combined Federal and Provincial Tax Rate is reduced to 11.7% on the first $500,000 of cumulative income.
Let’s looks at an example: Theodoros and Patricia dreamed of owning their own restaurant. They incorporate ABC Fine Foods: Each holding 50 common shares.
The business is very profitable earning $600,000 of active business income. The first $500,000 of taxable income is taxed at 11.7%, the remaining $100,000 will be taxed at 26.5%. Total income tax liability for ABC Fine Foods is $85,000.
Theodoros and Patricia can pay themselves a salary, a bonus, or a dividend. Or any combination of salary, bonus, or dividend. They will pay income tax on the amounts received.
If ABC Fine Foods accrues a bonus for the shareholders at year end, it must be paid to them within 180 days after the end of corporation’s taxation year. This is an acceptable way to defer income tax.
Patricia did not work at the restaurant: she took care of her mother. She cannot be paid a salary, nor bonus, but she can be paid a dividend. This is an acceptable way to split income.
ABC Fine Foods can loan money to Theodoros and Patricia, and if the loan is repaid within 1 year, after the end of the corporation’s year end, and it is not part of series of loans and repayments, it will not be included in their income.
If the loan is interest free, there is a deemed interest benefit that must be calculated and reported by the shareholders. The current CRA prescribed rate on loans to shareholders is 3%.
Sole Proprietorship or Partnership
If ABC Fine Foods was not incorporated, and operated as a partnership, then Theodoros and Patricia would each report $300,000 on their personal tax return as their share of the business income.
Recommendation
Incorporate: There is a tax saving in operating a business through a corporation.
The total combined tax to be paid by the corporation and the tax to be paid by shareholders on the salary or dividends they receive, will be significantly less that tax they would otherwise pay through a partnership.
Incorporating will incur legal costs and T2 Corporate Tax Returns will need to be filed annually.
If you are currently operating a business as a sole proprietor or partnership, and would like to transfer it to a corporation, this can be done, by what is called a Section 85 rollover. In A future article, we will explain the process in detail.
There are other tax benefits and other issues to consider in incorporating a business. For more information, regarding your specific situation, please consult with your tax advisor.