A common question we receive is whether an individual should incorporate their side hustle. There is not a definitive solution as each situation is different, however, we will provide context of what to consider from a tax perspective.
Question An Individual is planning to start a part-time business and expects to earn $30,000 per year after paying related expenses. The individual has a full-time job where they earn $50,000 per year. This puts them in a 28% marginal tax bracket (they will pay at least $0.28 of tax for every additional $1 of income earned). From a tax perspective, should the individual incorporate the part-time business? Factors to Consider One of the largest benefits of incorporating is the deferral of personal taxes. The combined Federal/BC corporate tax rate for active business income is 11%. Personal taxes are not incurred until a dividend or salary is paid out from the corporation to the individual, the time lag between paying taxes in a corporation and paying the associated tax at the personal level is referred to as "the deferral of personal tax". The longer this deferral lasts, the larger the potential benefit will be. The deferral advantage is based on the principal of the "Time Value of Money"; cash today is worth more than cash tomorrow due to its immediate income earning potential. However, when deciding whether to incorporate there are many client specific qualitative and quantitative factors to consider. For example:
Does the individual require the excess cash flow earned from the side business to cover household/living expenses? If so, the benefits of the tax deferral are diminished.
If the individual incorporates, are they planning to invest the retained cash? Would it be a reinvestment in the side business or in passive investments?
If investing in passive investments, would it be in income producing assets or assets that produce no income but will appreciate?
These are important considerations as passive investment income earned through corporations is initially taxed at a high rate of 50.67% which greatly reduces the advantages of the personal tax deferral. A portion of this tax is recovered (30.67%) once a dividend is paid out to the individual. However, the payment of the dividend will trigger personal tax on the dividend income, ending the tax deferral advantage the corporation provides.
If the plan is to reinvest in the operations of the business, the deferral of the personal level of tax will provide greater after-tax cash flow to purchase capital assets for the business and to cover operating expenses that are forecasted in future years. The tax deferral of incorporating can be significant. For example, a 17% tax deferral results when considering the corporate tax rate of 11%, and the individuals marginal personal tax rate of 28%. When generating $30,000 of taxable income, the result would be $5,100 of tax deferred per year through a corporation. This deferral of tax will eventually end once a dividend or salary is paid from the corporation to the individual. Therefore, the true benefit of this tax deferral depends on the number of years the individual intends to defer the tax, the projected use of funds, and their projected future personal tax bracket. Lastly, an important expense to consider is accounting and legal costs. Accounting costs will greatly vary depending on if the individual completes their own bookkeeping or has a bookkeeper/accountant handle the task. The bookkeeping should be considered an unavoidable cost as the individual would still have to bookkeep for business activities if not incorporated; sole proprietors must record and report business income and expenses on their personal tax return. The annual cost specific to the corporation would be for the year-end corporate tax return and related services. These costs will partially reduce the advantage of the tax deferral in this scenario. Therefore, factors such as the length of the deferral and future personal tax rates would be a strong case for whether to incorporate in this situation. Moreover, an individual will likely incur legal fees to incorporate as well.
However, this is always an extremely dynamic and individual specific situation. If we adjust the variables the analysis will greatly change. For example, if the individual earned $100,000 of salary instead of $50,000, their marginal tax rate would be higher (38% instead of 28% in the original scenario). Therefore, the tax deferral would be $8,100 instead of $5,100. When factoring in the accounting and legal costs, the individual earning $50,000 of salary per year may not receive enough value to incorporate; the individual earning $100,000 would likely derive significant value through incorporation. This can be a very integrated situation requiring a detailed analysis, this should not be treated as a one size fits all approach, there are many other relevant and complex factors to consider. When you work with TSB Chartered Professional Accountant Inc., we will create a custom-tailored plan integrating the necessary qualitative and quantitative factors to develop the best solution for you! As your trusted business advisors, we conduct the necessary tax planning to determine the most tax efficient method of structuring your business and drawing funds from the corporation to minimize your tax bill from the corporate to personal level. For a business owner, deciding whether to incorporate can be an overwhelming task. Contact us today to receive the answers you need; a quick conversation could save you thousands in taxes!
Tristan Bagri, CPA
Founder & Director
Tristan@tsbcpa.ca
778-707-4699