As an American in Canada, should I incorporate my business?

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Question

Hi Phil

I got your email from a client of mine and I hope you can help me sort through some issues. I would be more than happy to schedule a proper consultation if required.

I moved back to Canada 5 years ago to start my consulting practice. I’m also both a Canadian and US citizen. I have an account help with my annual filings, but I’m not really happy with the service he provides. I don’t mind the cost so much, but everything is always done at the last minute, even though I bring him my tax stuff in early March. Last year I didn’t get my US returns completed until late June.

Some of my colleagues are surprised that I’m not incorporated

Anyways, here is my situation, I would love to hear your thoughts. I run a relatively success marketing consulting practice and have around 50 large corporate clients. I’m making around $400,000 net each year. Some of my colleagues are surprised that I’m not incorporated. I brought this up with my current US accountant and he simply stated that it would be too much extra filing requirements and would make my life more difficult. I don’t mind paying more to file my taxes if I can save more tax overall. I’m not married, so income splitting won’t work, but I would like to entertain incorporation if it makes sense for me.

Thoughts on the above??

Thanks

XXXXXX

Answer

Hi XXXXX

Thanks for the email. I’ll do my best to provide some insight, however it may make sense to arrange a call to flush out some more of you details.

Incorporation for our US citizen clients has been quite challenging over the last few years. We had two big changes that affected these clients. First, under the new 965 IRS code section all retained earnings of foreign companies controlled by US clients were taxed in the US. Fortunately some clients were able to manage by using prior year foreign tax credits, however some clients were required to accelerate Canadian tax to mitigate a large US tax bill. For 2018 we have another significant change that will affect any US person thinking of incorporating their Canadian business. The Global Intangible Low-taxed Income rules, or GILTI also affect foreign companies controlled by US persons. Under these new rules (in very general terms) the active income earned in the company will not be deferred and will be taxed in the US. Fortunately there are some strategies that seem to allow our clients to continue to defer Canadian earnings.

I only mention these changes above to underscore how complex these rules can become and how volatile these changes can be.

So, back to your original question, should you incorporate?

Notwithstanding the US rules, whether someone should incorporate for Canadian purposes is a question of fact. In most cases there are 3 main advantages:

Income Splitting – Most of these advantages have been eliminated under the new Canadian rules unless your spouse or kids actually work for the business.

Income Deferral – This likely be the largest advantage for you in incorporating. Generally speaking the more money you can leave in the company taxed at lower corporate tax rates the more you can invest internally. You will however eventually be capped by the new passive investment rules rolled out by the liberals.

Tax Free Sale of Business Shares – For shareholders who have the ability to sell their shares there is a potential to shelter the gain from tax using the qualified small business share exemption.

Assuming your shares will be quite difficult to sell as a consulting practice the most significant advantage to incorporation will likely be deferral of income. For example, assume you earn $400,000 net and only need to pull out $100,000 for living expenses. The $300,000 will be taxed at very low corporate rates (around 13%). The difference can be invested in passive assets or reinvested into the business. Under the current corporate rules the cap on investment income (before your small business deduction is decreased) will be reached once you have passive income (dividends, capital gains, interest or rental) of $50,000.

In most cases, if shareholders can defer a significant amount each year, and assuming you can also take advantage of your RRSP limit room, incorporation can make lots of sense in the long term.

The analysis above is only from a Canadian perspective and US tax rules need to be assessed. I won’t be able to flush out the specifics of these rules in this email, however the following summary should give you some perspective before we speak:

You’ll need to file form 5471 with your 1040 return each year. This form tracks your Canadian corporate income for US tax purposes. You’ll need to track your active income for GILTI purposes and passive income for subpart F purposes. The compliance costs can be high for these type of filing, however will be exceed the advantages of incorporation listed above.

The tax free sale of shares outline above will not apply for US purposes, therefore this advantage is significantly reduced if you thought these shares could be sold in the future.

I’ve outlined quite a bit above and we should get on a call to flush out more of the details. Please feel free to reach out via email at phil@hutcheson.ca or on my cell at 250-661-9417.

Cheers

Phil


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