This is a continuation post of my blog series about running your blog as a corporation. While most bloggers are not at this stage yet, it’ll come in handy when you finally reach it.
Aside from the limited liability a corporation offers, the other benefit for setting one up is they are taxed at a lower rate than employment income. In Canada, the rate is so low it’s almost bordering on ridiculous (not that I’m complaining). A Canadian Controlled Private Corp is taxed at just 15.5% on its first $400,000 of net income. If you made that much as an employee, you’ll be at the maximum 50% tax rate.
Because of the huge gap between corporate and personal tax rates, many corp owners choose to withdraw minimum amounts for themselves and keep the rest of the profits in corporate retain earnings. However, doing it this way will create problems down the road.
Losing Operating Company Status
The 15.5% corporate tax rate only applies to operating companies, These are companies that exist to provide a product or service. The problem comes when the cash build up in retain earnings become so great that you are no longer considered an operating company for tax purposes. An example should better explain this.
Say the corp is netting $300,000 a year after tax and dividend payments. It’ll be pretty stupid just to leave that money sitting in the bank. At the very least, you would put it in some kind of investment to earn some interest on it – like a T Bill or bond. As the years goes by, and with more company profits piling in, this chunk of cash will get bigger and bigger and account for more and more of the corporate income. If retain earnings were allowed to build up to $3 million and the company can make 10% return on that money, it would mean the company’s interest income would match its operating income. At this point, the tax man can rule that you are no longer an operating corp but a holding corp instead. A holding corp is taxed at a much higher rate than an operating corp (it’s still lower than the personal rate however).
Another problem that can come up if you keep too much retain earnings is potential lawsuits. Blood sucking lawyers love suing companies that have a lot of cash. The solution to all this is to get the money out of the company without incurring a tax liability. You do this by setting up a separate holding company.
No Dividend Cap On Holding Companies
The holding corp’s sole purpose is to invest the after tax income of the operating corp. While there are limits on how much tax-free dividend an operating corp can pay an individual, there are no limits on how much an operating corp can give its holding corp – you can transfer up to 100% of the retain earnings to the holding corp without incurring a tax liability to the holding company. The holding corp would then invest that money and any income made will be taxed at the holding corp rate. The operating corp will be able to retain its operating status and lower tax rate.
The above applies to Canadian tax laws. In the US, Uncle Sam would never declare your operating corp a holding corp. This is because the tax rate on a holding corp is lower than an operating corp. As with all financial advice, please see a qualified professional to find the best plan for you.