When you are planning to incorporate your business as an IT contractor or freelancer in Canada, it’s important to know what that involves. Incorporation is the legal process of creating a separate entity for your business, distinct from yourself as an individual. This entity is recognized by law and can own assets, enter contracts and be liable for debts and obligations independently of you. To get started, you’ll need to pick a unique name for your business, prepare the necessary paperwork, and file it with the relevant government authority.
In Canada, you can choose to incorporate either federally or provincially. A federal corporation provides the ability to operate across the country under the same registered name, while provincial incorporation limits your operations to a specific province or territory. Determining which route suits your business objectives is a key decision you’ll need to make.
Understanding the process of incorporation is important for deciding whether or not it is suitable for your business operations and financial objectives. Being a contractor, this can be extremely fulfilling but also has added complexities that can affect your business overall strategy.
Advantages of Incorporating Your Business as a Contractor
As a contractor in Canada, incorporating your business isn’t just about tax savings; it opens the door to various financial, legal and operational benefits. By setting up as a corporation, you can drive your professional growth while also feeling more secure about your finances.
1. Financial Benefits
- Tax Savings: Incorporation allows you to pay taxes at the corporate tax rate, which is generally lower than the personal tax rate. You can defer personal income tax by leaving profits in the corporation instead of withdrawing them immediately.
- Income Splitting: As an incorporated contractor, you can engage in income splitting by paying dividends to family members in lower tax brackets, within permissible legal limits.
- Business Deductions: You are eligible to deduct various business expenses, including travel, office supplies, vehicle costs, and professional fees.
- Tax-Free Retained Earnings: Earnings not immediately required can be retained within the corporation and reinvested into the business without incurring personal tax.
2. Legal Protections
- Limited Liability: Operating as a corporation establishes legal separation between your personal assets and business liabilities. In situations involving lawsuits or debts, this separation shields your personal assets from business-related risks.
- Professional Credibility: Incorporating your business enhances its legitimacy in the eyes of clients, partners, and industry associates. Many corporations and organizations prefer to do business with incorporated entities.
3. Operational Flexibility
- Access to Capital: Corporations often find it easier to secure loans, attract investors and access financing options compared to sole proprietorships or partnerships. This can be crucial for scaling your operations.
- Continuous Existence: Incorporated businesses has no limit on its life span. The corporation continues to exist, independent of ownership, which enables easy transitions, unlike sole proprietorships.
Key Tax Benefits of Incorporation for Canadian Contractors
When you incorporate your contractor business in Canada, you gain access to massive tax savings that sole proprietors don’t get. These benefits can help you keep more of your earnings, to maximize financial planning, and to minimize tax liabilities.
Lower Corporate Tax Rates
Corporate tax rates are generally lower than individual income tax rates in Canada. When your business is incorporated, profits earned within the corporation are taxed at the corporate rate, which can be substantially less than the rate applied to personal income. For smaller businesses, the Small Business Deduction (SBD) allows qualifying corporations to pay reduced taxes on their first $500,000 of active business income. This can lead to considerable savings compared to being taxed entirely at personal income rates.
Future Retirement and Investment Options
You can leverage a corporation to create a tax-efficient retirement plan. A corporation allows the establishment of an Individual Pension Plan (IPP) or the making of contributions to a Registered Retirement Savings Plan (RRSP), offering potential tax advantages. Furthermore, retaining earnings within the company can help fund future investments or projects, all while benefiting from lower corporate tax rates.
Capital Gains and Lifetime Exemption
Selling shares of your incorporated business may qualify you for the Lifetime Capital Gains Exemption (LCGE) when it’s time to sell or exit the business. This exemption really lower the taxable portion of capital gains, resulting in substantial savings for the corporation upon its disposition.
By incorporating, you establish a versatile financial structure that enables you to strategically plan, invest and maximize the benefits that Canadian tax laws provide for contractors.
Income Splitting Opportunities
Income splitting can be a tax-effective strategy available to incorporated contractors in Canada. When you incorporate, you can structure your business in a way that distributes income among family members. This can reduce the overall tax burden on your business income by taking advantage of lower individual tax brackets for your spouse, children, or other family members. To leverage this opportunity, you need to ensure that the individuals involved in income splitting meet specific eligibility requirements set by the Canada Revenue Agency (CRA).
One common strategy for income splitting is issuing dividends to family members who hold shares in your corporation. If your spouse or adult children are shareholders in the business, they can receive dividends from the corporation. Since dividends are taxed at the individual’s personal income rate, shifting income to family members with lower tax rates can result in significant tax savings. However, you must comply with CRA rules related to the Tax on Split Income (TOSI), which considers whether the dividends or income distributions are reasonable and reflective of the recipient’s contribution to the business.
Alternatively, you can employ family members in your business and pay them a reasonable salary for their legitimate work. Salaries paid to family members are deductible as business expenses for your corporation, further reducing taxable income at the corporate level. This approach works particularly well if the family members are already involved in operations such as administrative tasks, marketing, or other legitimate business functions.
Corporate Business Expense Deductions
When incorporated, you keep your personal and business finances separate, which helps formalize your contracting expenses. This setup is recognized by the Canada Revenue Agency (CRA) and enables you to claim extra deductions, lowering your taxable income.
Through incorporation, you can deduct routine operating expenses such as office supplies, software subscriptions, and marketing materials. Rent for a dedicated office space or the cost of maintaining a home office is also deductible, provided the area is used primarily for business purposes. Similarly, expenses for utilities, internet and phone services are claimable if they serve your business operations.
Another major advantage of incorporation is the ability to deduct vehicle expenses. If you use a personal vehicle for work-related travel such as visiting clients or attending meetings, you can claim expenses for mileage, fuel, maintenance and vehicle insurance. This can be particularly beneficial if your business requires frequent travel. However, you must ensure accurate records are maintained to differentiate between personal and business use.
Incorporation also facilitates the deduction of employee or contractor salaries. If your business hires subcontractors or employees, their wages are deductible from your corporate earnings. Even your own salary, if you’re paying yourself a formal income, can reduce the corporation’s taxable income.
Pre-incorporation professional fees such as legal advice, accounting services and financial planning are also deductible. Training costs for industry certifications or skill enhancement courses can also be written off, enhancing your business’s operational efficiency while minimizing tax liabilities.
Should You Pay Yourself Salary or Dividends as a Contractor
When you incorporate your business in Canada, one potential drawback you may encounter is the issue of double taxation. This occurs when corporate earnings are taxed at the company level and then again at the personal level when you withdraw those earnings as dividends or remuneration.
At the corporate level, your company’s profits are subject to the corporate income tax rate, which can vary depending on your province or territory. Although Canadian businesses generally benefit from the Small Business Deduction, reducing the corporate tax rate on the first $500,000 of active income, this is only the first level of taxation. When you decide to access your earnings personally, such as by paying yourself dividends, you’ll be taxed again based on your marginal personal income tax rate.
This dual layer of taxation can erode a significant portion of your earnings if not carefully planned. While Canada’s tax system mitigates this to an extent through the dividend tax credit, you still need to strategize to minimize your overall tax burden. For instance, the corporate structure may require you to navigate withholding taxes or balance how profits are retained or distributed.
If you take your earnings as a salary instead of dividends, you can avoid the double taxation concern; however, this approach comes with its own complexities. Salaries are subject to Canada Pension Plan (CPP) contributions, as well as employment insurance (EI) premiums, which reduce your take-home pay. The choice between salary and dividends will depend on your long-term financial goals and other variables, like your personal cash flow needs and tax bracket. To effectively manage the potential impacts of double taxation, consider consulting with a tax professional.
Legal and Administrative Responsibilities of Incorporation
When you incorporate your business in Canada, you take on a range of legal and administrative responsibilities that must be diligently managed to ensure compliance and proper operation. By incorporating, especially as a contractor, your business officially becomes its own separate legal entity, which means you need to follow certain rules and processes.
Filing Articles of Incorporation
One of the first steps is filing the articles of incorporation with the appropriate federal or provincial authority, depending on where your business is based. This paperwork will require you to choose a business name, outline your share structure and identify who the directors of your corporation will be. Each region has its unique requirements, so it’s a good to get familiar with those specific rules.
Maintaining Records and Corporate Documents
After you set up your corporation, you’ll have to keep careful corporate records. This means tracking things like meeting notes, resolutions, and shareholder details. These documents are key for both legal and business reasons, so they should be kept up-to-date and readily accessible. Keeping a corporate minute book is also generally advisable for organizational purposes.
Annual Income Tax Return Filings
You must file annual corporate returns separate from your personal tax filings to ensure your corporation remains in good standing with the Canada Revenue Agency (CRA). These filings include information such as the corporation’s address, directors and shareholders. Failing to file can result in penalties or even the dissolution of your corporation.
Tax Compliance Obligations
As a corporation, you are required to complete corporate tax filings. This includes meeting deadlines for filing your T2 corporate income tax return and paying any applicable corporate taxes. Keep track of financial statements, invoices, and receipts, as these are essential for accurate filings and may be requested in the event of an audit.
Employment Obligations if Hiring
If you plan to hire employees or subcontractors, you must follow employment laws, including issuing contracts, adhering to payroll requirements, and remitting Employment Insurance (EI), the Canada Pension Plan (CPP), and income tax deductions to the Canada Revenue Agency (CRA). Compliance is critical to avoid penalties.
Provincial Licensing Requirements
In certain provinces or territories, additional licenses or permits may be needed depending on the type of work your business performs. Being proactive about licensing ensures smooth operations and prevents legal complications.
Should You Incorporate as a Contractor in Canada?
Deciding whether to incorporate your business as a contractor in Canada depends on your specific financial situation, long-term goals, and professional circumstances. Incorporation offers several advantages, but it also requires careful evaluation of its implications.
If you’re making over a certain amount each year, usually between $60,000 and $100,000, it could be beneficial to incorporate your business. This lets you take advantage of the corporate tax rate, which is usually lower than your personal income tax rate. If you keep a portion of your earnings inside the corporation, you can put off paying personal taxes and reinvest funds back into your business.
That said, there are extra costs and responsibilities that come with incorporating. You will need to file corporate tax returns, maintain detailed records and follow compliance requirements (such as issuing T4 slips if you pay yourself a salary). These are some of the tasks which may need you to hire an accountant, which adds to your operational expenses. Good luck!
