Navaz Murji, CGA, answers some common questions we hear from our clients:
- Should You Incorporate?
- This is a question many small business owners face at some time. Often they will say to us, “If I fill out a short form the Canada Revenue Agency gets a chunk of money. If I fill out a long form the accountant keeps the money. But when I incorporate, it seems all the professionals dig into my wallet, because I created a new taxpayer – a corporate entity.” So, how do you know if you should take the step of incorporating?
This topic should be addressed by four professionals: A lawyer and an insurance agent to cover legal liability issues, a mortgage broker or banker to address the difficulties in obtaining commercial financing, and an accountant to deal with taxation issues. However, when I am discussing those items that should be reviewed with the three other professionals (the lawyer, banker, and insurance agent), I am only referring to my personal experience and my clients’ experiences, not as a professional. But these pointers will help you have a productive dialogue with the other professionals, so that you can make a decision for yourself.
Firstly, from a tax perspective it is important to understand the difference between active and passive income. Passive income is income earned from investments such as rental income, interest, and dividend income. Active income is income from businesses such as retail stores, restaurants, professional practices, developers, and rental income in a corporation that has more than five full time employees. The first $500,000 from these businesses, which are Canadian Controlled Private Corporations (CCPC), are taxed at the low rate of corporate tax for the income that you leave in the corporation – usually around 15% depending on your province. Income from passive sources is taxed at the highest rate, around 46% depending upon your province.
As a result of this, if you are purchasing rental properties it is not advisable to incorporate. If you are a builder, land developer, or a “flipper’” then you should consider incorporating. If you are buying multi-family buildings in Alberta – the banks will make you incorporate. If you run an active small business or have a professional practice, you should consider incorporation.
The main disadvantage to incorporating for single-family homes is that the cost and complexity of maintaining and creating a corporation will be higher. Your accounting fees are higher, as you will be required to maintain a double entry bookkeeping system to create accurate financial statements. Corporate tax returns take longer to prepare, and working paper files have to be more detailed. Your insurance costs will be higher too, as you will be required to buy a commercial policy. Your banking costs will go up as commercial bank account fees, interest rates, and closing documentation costs are all higher.
My banker tells me that anytime I borrow funds in a corporation they will ask for personal guarantees, which means that the banks can come after me personally for the loan. This document is so ironclad, that even if I want to file for bankruptcy, the bankers have to approve it. They only do this if it benefits them. From a banker’s perspective, why would they risk loaning me the money if I don’t have faith in my project?
Secondly, there are only a few lenders who like to work with a corporation. So you limit the number of bankers that will deal with you. Their costs are also higher when dealing with commercial loans.
When you are setting up a corporation, you may want to also consider setting up a Family Trust. This depends on your investment strategies, your current family situation, and current finances based on your spending habits. If you generate excess cash for reinvestment, you have a potential savings of 26% hence incorporation would be profitable for you.
- This is a question many small business owners face at some time. Often they will say to us, “If I fill out a short form the Canada Revenue Agency gets a chunk of money. If I fill out a long form the accountant keeps the money. But when I incorporate, it seems all the professionals dig into my wallet, because I created a new taxpayer – a corporate entity.” So, how do you know if you should take the step of incorporating?
- Choosing Insurance
- When I talk to my insurance agent, he tells me most lawsuits are frivolous and small. But you should still make sure you have adequate coverage. Buy the best liability insurance you can get (at least a million dollars). Add to this an umbrella policy, with coverage of between $5 and $10 million. When a claim comes in, inform your insurance company immediately. They will deal with the person suing you – as this person will most likely hire a lawyer on a retainer.
But don’t forget, insurance companies have full time lawyers seeking reasons not to pay a claim. The insurance company may try to get out of paying a claim, taking the position that it is not covered by the policy. If this happens, hire your own lawyer, one who specializes in suing insurance companies. You would like the insurance company to hire a lawyer to defend you from the lawsuit.
A lawyer will tell you – the frivolous lawsuits will stop at the door of the corporation – unless they go after you personally as a director for being negligent. The difficulty with lawsuits is they take time and money. If the other party has hired a lawyer on a retainer, you have to pay your own lawyer at an hourly rate. As a result, the person with the deepest pockets can keep it going and the one without money has to settle. Who do you think will get the best deal? If such an event took place, you would lose the equity in that property if your insurance company did not cover it.
- When I talk to my insurance agent, he tells me most lawsuits are frivolous and small. But you should still make sure you have adequate coverage. Buy the best liability insurance you can get (at least a million dollars). Add to this an umbrella policy, with coverage of between $5 and $10 million. When a claim comes in, inform your insurance company immediately. They will deal with the person suing you – as this person will most likely hire a lawyer on a retainer.
- Interest Deductible Loans
- All interest paid on monies borrowed for investment purposes are tax deductible at this time. The reason for the caveat is the Canada Revenue Agency has been tinkering with the rules for the last few years and they do not have a definitive answer yet. It is amazing that all monies borrowed for the stock market are tax deductible, even though some of the stocks have no potential for earning dividend income. Yet when it comes to real estate, they are trying to limit the amount of interest, so that you cannot get a loss from a property. This is not law yet and we hope it never will be! So if you get a chance – complain to your MP, Finance Minister, Minister of National Revenue and the Prime Minister about the unfair treatment of real estate investors, as compared to stock market investors.
Overall, your objective is always to pay off loans where the interest is not deductible for tax reasons. If you borrow $100,000 and your interest rate is 6%, your interest payments would be $6,000. If the interest is tax deductible, your loan just got cheaper by the amount of taxes you save based on your marginal tax bracket. If your marginal tax rate is 22% – your tax savings are $6,000 x 22% = $1,320. If you’re in the 42% bracket, your savings would be $2,520.
So how do you make the interest on the loans tax deductible? Typically CRA follows the direct flow of money. So if you borrow $100,000, deposit it in your lawyers’ trust account, and use it for a down payment on a rental property – it becomes directly traceable.
What would happen if you take the $100,000 and put it in your personal bank account? It gets messy when there are other transactions. The guiding principle is direct flow – keep it that way and don’t mix business and personal expenses. CRA does not care to understand your circumstances. Nor do they have a desire to make an exception for you – just follow the rules.
- All interest paid on monies borrowed for investment purposes are tax deductible at this time. The reason for the caveat is the Canada Revenue Agency has been tinkering with the rules for the last few years and they do not have a definitive answer yet. It is amazing that all monies borrowed for the stock market are tax deductible, even though some of the stocks have no potential for earning dividend income. Yet when it comes to real estate, they are trying to limit the amount of interest, so that you cannot get a loss from a property. This is not law yet and we hope it never will be! So if you get a chance – complain to your MP, Finance Minister, Minister of National Revenue and the Prime Minister about the unfair treatment of real estate investors, as compared to stock market investors.
- Audit Process
- Usually CRA is focusing on areas where they think there is an error on your return. There are three types of audits, with each one demanding a progressively higher level of scrutiny and compliance. Regardless of the level of audit, we advise our clients to contact us first. If you follow the documentation and filing system – you will have no trouble responding to their request.
The least onerous is an information request. As soon as your return is filed, CRA computers will scan through the return, compare it with information from other sources, and generate a request for some specific information. This is done as a pre-assessment – prior to accepting your return or in the fall/early winter of the same year. It is our practice to try and respond within 48 hours.
The second is a desk audit. CRA will request you gather your information and send it to them. This is where clear, comprehensive records are invaluable. The easier it is for them to get the answers they need, the less likely you’ll have to struggle to prove your position. You simply send them the information.
The third audit is a full-blown audit. Handled poorly, this can severely impact your business.
One of the most important items to understand is the mindset of the auditor. Remember, their objective is to collect money in the easiest possible manner. Your objective is to protect your assets. They are not there because they have a personal agenda against you. Don’t make things worse by creating conflict. A cooperative, helpful approach and accurate records are your strongest allies in this situation.
In most cases I see clients having to pay because they didn’t have the proper documentation, even if their original claim may well have been valid according to tax regulations. I believe CRA is aware that many entrepreneurs are not very good at keeping accurate records. However, it is not their role to forgive poor bookkeeping. Sometimes you will get an auditor who will allow you to claim expenses based on reasonableness, but it is far simpler and less expensive in the long run to ensure your accounting records are complete and up-to-date.
Remember, CRA auditors have been trained to do audits and that is all they do. Some would be hard pressed to prepare financial statements, as it is a different discipline. But who do you think is going to win a debate between you and the auditor over allowable claims and expenses? They have the power and authority and their decision won’t impact their personal bottom line; but their choices can have a direct impact on your business or investment position. Again, complete and accurate bookkeeping records are the key tools you can use to attain a positive outcome.
Clients ask me – why was their return selected for an audit? CRA is very non-communicative about this issue. I suspect that the first reason could be that they spot numbers that are out of line with industry norms. Secondly, it could be industry-specific, where CRA suspects there is abuse or has found a pattern of non-compliance. Thirdly, certain line items – such as automotive, entertainment and travel expenses, are more prone to abuse.
Another situation that can generate an audit is third party information. For example, CRA may go to a land titles office and notice you sold a property and did not report it on your tax return. Similar information is available for cars from motor vehicle branches, or if they audit a car dealership. In that instance, they may notice one customer bringing in a lot of different cars, raising suspicions the person is selling cars and not reporting the transactions in their tax return.
Next would be late filers. It raises a flag that their records are likely not well organized, their paperwork is messy, and they would lose receipts. That makes them an easy target. Of course the reason the Canada Revenue Agency gives for an audit is random selection. This may be true in some cases. Once again, it emphasizes the need for scrupulous recordkeeping. Even if you are doing everything by the book, you might still face an audit.
- Usually CRA is focusing on areas where they think there is an error on your return. There are three types of audits, with each one demanding a progressively higher level of scrutiny and compliance. Regardless of the level of audit, we advise our clients to contact us first. If you follow the documentation and filing system – you will have no trouble responding to their request.