In Canada, there are two tax brackets for incorporated business income. The lower one, Small Business Deduction (SBD) rate is about 15%. The SBD is on the first $500,000 of income (up until a few years ago it was $400,000). Above $500,000 of income, the second ‘tax bracket’, the corporate rate is 26.5%. To illustrate: between $400K and $500K of income, $15,000 is tax payable. Between $500K and $600K of income, $26,500 is tax payable. This is a huge jump of 76.67%! However, due to the system of integration, the taxation activity flows down to the individual level when cash is paid out to the owner. The government taxes business income just as it would tax a non-incorporated sole proprietors income.
An example will illustrate why one shouldn’t fear the tax bracket change. Assume Sky Ltd. is owned by Jack. Sky Ltd. has $1,000,000 in income. If the owner was paid out $1,000,000 in salary, the income would drop to $0, and obviously there is no corporate tax on $0 in income. All of the income is taxed, at roughly 46%. In comparison, if Sky Ltd didn’t exist, and the owner made the money and claimed $1,000,000 in personal income, the same 46% tax would be paid. So, total corporate + individual tax with Sky Ltd equals the tax paid on the same income if there was no incorporation.
If $1,000,000 in income remained, corporate tax paid, and the rest paid in dividends, the tax system acts a little differently. The first $500,000 of corporate income will be taxed at 15% ($75,000), leaving $425,000 for dividends (let’s call this the low rate amount). The next $500,000 will be taxed at 26.5% ($132,500), leaving $367,500 in dividends (the high rate amount). Total Tax is $207,500.
At the individual level, $425,000 is grossed-up at 18%. $425,000 x 1.18 = $501,500. This is fairly close to the $500,000 taxed at the low rate. In fact, the government uses the gross-up in an attempt to make the income the same whether earned in a company or in a sole proprietorship. To account for the tax paid at the corporate level ($75,000), the government gives a Dividend Tax Credit equal to the 18% gross-up ($76,500). Not perfect, but fairly integrated. The dollar made in the corporation, when distributed as a dividend, is almost perfectly taxed only at the individual level.
What about the high rate amount? The second corporate tax level had a 26.5% rate, taking $132,500 from the $500,000 in our example. Here the gross-up is larger, and the dividend tax credit is larger, to ensure the money distributed to the shareholder is taxed only at the individual level. After the $132,500 tax, $367,500 remain. At the high rate, the gross-up is 38%. $367,500 x 38% = $139,650, so the personal income is now $507150. That’s not perfect, but close to bringing the personal income back to the original $500,000 taxed at the high rate. At the personal level, tax is paid at the individual’s tax rate, and the dividend tax credit of $139,650 is awarded. Not perfect, but this puts almost all tax at the individual level as if the corporation never existed.
Note that taking money out to get to the Small Business Deduction level means more tax is paid at the individual level. The highest individual tax level is 46%, so there is likely an opportunity to defer net tax by keeping it in the corporation.
The bottom line is that rushing out to spend corporate money to get under the $500,000 income threshold may not be wise. If you increase salary/dividends to avoid the 26.5% corporate tax rate, you will end up paying 41%-46% tax at the personal level. If you go out and spend money on extra office expenses, for every dollar you spend you will be saving 26.5 cents. (there are regulations enforcing reasonable limits on such expenses,too!) Is it wise to spend $1 to save $0.265? In conclusion, the 26.5% higher corporate rate is a concern, but avoiding it should not be an intense focus. As the saying goes, there are three things one can count on: life,death, and taxes.