This is a question that I am asked quite a bit, especially from higher income professionals (doctors, lawyers, etc.).
Unfortunately, my usual answer is: It depends…
Assuming you are treated as a contractor, not an employee, you have the options of being self-employed or to create a professional corporation (assuming you live in a jurisdiction where your professional body allows you to incorporate).
The initial test to incorporate or not is to determine whether you require all the income you earn to pay for your lifestyle. If the answer is yes, then, generally speaking, there is not a lot of tax savings in incorporating, as all the income going through your corporation flows out to you. There may be some minor savings by splitting your income between salary and dividend, but the savings are not significant.
Typically, the expenses you can claim through a corporation are the same expenses you can claim as a self-employed professional (automobile, phone, office, salaries to other people, membership dues, etc.)
Where the majority of the tax savings are created, are when you do not require all the income earned by your corporation and you can leave some of the income in the corporation to be taxed at the small business tax rate of approximately 14% (depending on which province you live in, it could be more or it could be less, but not by a lot). The 14% rate is on the first $500,000 in net income.
As an example, you have a net income of $250,000 and you only need $175,000 of this to fund your lifestyle, the $75,000 remaining is taxed at a lower tax rate in a corporation, than if you had to declare the entire $250,000 as net income when you are self-employed.
The concept is that this allows you to build up a nest egg in the corporation, then take this money out at some future time when you are not working, at a lower tax rate.
The recent changes by the federal government have caused some restrictions on the building up of savings within a professional corporation. The general concept is that any passive investment income earning more than $50,000 per year starts to cause your active business income to be taxed at a higher rate than the 14% mentioned above. The actual calculation is complex, so please consult a tax advisor.
Keep in mind, that even the higher tax rate inside the corporation that is charged is approximately 27%, which is much lower than the highest marginal tax rate in excess of 50% (again, the exact rate depending on the province of employment).
Another area that the federal government has tightened rules is income splitting and dividend splitting with family members. They have put in place a test around reasonableness and active engagement in the professional corporation. These rules are complex in nature, but basically would require the corporation to prove engagement by the spouse or other family members, or the income being split would be taxed at the highest marginal rate.
Disclaimer: This article is for general information purposes and may not apply to every person reading it. Due to the complex nature of taxation, you should consult a tax advisor prior to making any decisions based around the above general information.
Written by Peter Simpson, CPA, CMA, Simpson and Associates
CRA Chief Financial Officer
About Simpson and Associates
Simpson and Associates is a full-service accounting firm, located in downtown Burlington. Peter Simpson, CPA, CMA, has over 20 years of tax and management accounting experience. Services offered range from personal tax, corporate tax, management consulting, part-time CFO/controllership and assistance with SRED applications. Some of the industries that we specialize in are entertainment, manufacturing, software development and professional services. We have alliances with other professional service firms such as lawyers, bookkeepers, HR consultants, private financiers and valuators