The taxation of small business is perennially a hot topic, in the news, on social media and among Canadians in general, especially around election time. A narrative introduced into this election is that small businesses are a vehicle utilized by the wealthy to avoid tax.
Earning income through a small business does not in any way reduce taxes- it merely defers taxes on active business income until dividends are paid out to shareholders. There is no reduction or deferral of taxes on investment income earned in a corporation. Further, the deductions available to corporations are also available to individuals operating as sole proprietors, so tax savings do not simply occur just by virtue of operating through a corporation.
A basic concept of the Canadian income tax system, called integration, is that there is supposed to be no tax difference between business income earned personally and income earned through a corporation. Because corporate tax rates are constantly changing and the applicable tax rate often depends on the type of business a corporation is engaged in, perfect integration might very well be impossible. With current tax rates, there is a slightly lower tax liability for small business corporations operating in Ontario which are eligible for the small-business deduction, though any tax savings that result are extremely nominal. Results vary slightly for different provinces.
There is a tax benefit that comes by way of delaying taxes, referred to as tax deferral. For an individual who earns income through a corporation, there are two levels of taxes: tax paid in the corporation on income earned during the corporation's taxation year, and tax paid at a shareholder's individual marginal rates when corporate profits are paid out in the form of dividends. A dividend tax credit in effect offsets the corporate taxes already paid on the income, so that the overall tax is the same as if the income had been earned personally. There is a deferral of tax on corporate profits that are not paid out to shareholders, however the deferral advantage comes to an end when dividends are taken out of the corporation and taxed to the shareholder. Tax deferrals on active business income did not come into being by chance; there are practical justifications for their existence. The policy reason for lower tax rates on profits retained within a corporation incentivizes spending on business expansion, for equipment purchases, research and development and hiring personnel. A tax deferral is only possible on active business income earned through a Canadian-Controlled Private Corporation -investment income earned is effectively taxed at the highest marginal rate for individuals. Wealthy individuals cannot hold their stock portfolios through their corporation to achieve a tax deferral advantage.
Aside from the ability to defer taxes on active business income, individuals carrying on business as sole proprietors are entitled to the same deductions as incorporated businesses. They are able to claim reasonable expenses for equipment and supplies used to produce active business income and can claim tax depreciation on capital assets. While there may be other advantages to incorporation, such as limiting personal liability, they have nothing to do with the tax treatment of small businesses and are separate issues of their own.
Earning business income through a corporation instead of as an individual allows for the deferral of tax, but taxes are not reduced. Corporations, and especially small businesses, enjoy low tax rates on active business income to allow them more flexibility for operations and to encourage investment, but whenever income gets moved out to shareholders by way of a dividend, CRA is ready, willing and able to levy tax.
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