"The hardest thing in the world to understand is the income tax."
Should You Incorporate?
Author: Brad Howland
First Posted: November, 2002
As a working musician, have you ever wondered whether you should incorporate yourself to save income taxes? Perhaps you read somewhere that corporations pay less tax than individuals do, or perhaps you know somebody who has an incorporated business and you want to know why. This article discusses the advantages and disadvantages of incorporation for musicians. Although the information presented here is related to Canada, it will also be useful for U.S. musicians.
The Pros and Cons
The two main advantages to incorporating a business are:
- Limitation of liability: the owners of the business are no longer responsible for mistakes made by the business, and can't be taken to court for them. They are no longer liable for the debts of the business.
- Lower tax rates: if the business qualifies for the "Small Business Deduction" (most musicians will), the first $200,000 of income is taxed at roughly 19%. Income reported on a personal tax return is taxed at roughly 30-40% combined federal and provincial, depending on your income level.
However, business is taxed on 100% of its income because there are no personal exemptions, so at lower income levels the personal income tax rate is usually better. At what point does the lower corporate tax rate begin to make a difference? Well, after playing around with my income tax software for a while, I found that $30,000 seems to be the level at which the lower rates begin to have an effect.
You probably don't want to leave your money in the business forever. Eventually you will withdraw it and it will be taxed at the higher, personal levels. So, this mythical, lower tax rate for corporations is really just a tax postponement, not an actual tax savings.
There is an opportunity to save tax if your income fluctuates wildly over time. You could avoid "spikes" in your personal income level that might push you up into a higher tax bracket, by withdrawing cash from the business at a steady rate. In order to take advantage of this technique, you need a high enough income to live on while you "save" money in the business.
The main disadvantages to incorporation are:
- Inability to deduct losses from personal income: it's better for a business to be unincorporated in the early years, when losses are more likely to occur. Those losses can then be deducted from the owner's other personal income, such as employment, investment, real estate, etc.
- Fees and filing requirements: there is a good deal of extra bookkeeping and accounting that must be done, which I'll go into below.
How to Incorporate
There are two routes you can take to incorporating your business: hire a lawyer or do it yourself. I checked with my lawyer and his fee is currently $950 - $1,000. About half of this amount is to cover the filing fees for incorporation, which you still have to pay even if you do it yourself.
Doing it yourself is more complicated but saves you the lawyer's fee. Self-Counsel Press publishes the only worthwhile guidebook I know of--in my province it's known as the Incorporation Guide for BC. It can usually be found in bookstores and office supply stores, or you can order it directly from the publisher over the Internet. The current cost for the book is $21.95, and there is a forms kit that comes with it for $24.95. You can look at this book and see if you feel comfortable doing it by yourself. If not, hire a lawyer.
You need to decide whether to incorporate provincially or federally. The provincial incorporation fees are much cheaper, so unless you do business in more than one province, provincial is the way to go. You can always add more provinces later.
Transferring Money Out
You need to decide how you will get money out of the business and into your hands. One method is to hire yourself or your family members as employees. This is a legitimate technique for income splitting (and saving tax), as long as the pay is reasonable for the work performed. You have to keep payroll records, calculate and submit deductions such as EI, CPP, and income tax withheld (but not EI on your own salary–if you are a 100% shareholder your business can't contribute to Employment Insurance on your own behalf), and file T4 slips for your employees.
Another method is to pay the shareholders dividends from the company. The dividends are taxed at a low rate in your hands because of the "Dividend Tax Credit," but are not deductible from the gross income of the business, so there is no real tax advantage when this method is used.
Another method is to claim a deduction on the business return for "Management Fees" or "Directors Fees," and include them on your personal return. However, the CCRA still considers these fees to be employment income and requires you issue a T4 to yourself.
Yet another method is for the owners to declare a bonus for themselves and their employees. You can deduct the bonus from the income of the business when it is declared, but it doesn't have to be included in the income of the recipients for 180 days, so this is another way to postpone income tax.
Part of the process of incorporation is doing a name search, which costs about $30. You should pick three different business names in case your first choice is already taken. A name search is also required by many banks to open a business account.
Corporations are required to hold annual general meetings, however, this can be waived if all the shareholders agree. Corporations are also expected to have their annual financial statements audited by an accountant, but again this can be waived with mutual consent. One thing that can't be waived is the need to file an annual report. The fee for this is $35, and starting this year in BC you must file this online, which costs another $1.50 or so.
At tax time you must file two separate tax returns: your personal T1 return and a T2 Corporation Income Tax Return. The filing requirements are more stringent for corporations than they are for individuals. On a personal return with business income you provide an income statement for the business, but on a corporate return you must provide an income statement, balance statements for the beginning and end of the fiscal year, and GIFI statements. You will pay your income tax preparer more money at tax time!
It's probably not a good idea for most musicians to incorporate. The oft-touted, lower tax rates are really just tax postponements that many musicians can't take advantage of. Possible exceptions are those who make lots of money that fluctuates wildly over time. People in this situation can benefit from the "smoothing out" effect of withdrawing income from the business at a steady rate. Musicians don't really require the other main benefit, limitation of liability, because we aren't likely to get sued for, say, playing wrong notes in a concert. Therefore, for the majority of us, the time and expense of setting up a corporation are difficult to justify.
Related Web Sites
Legal and small business books.
Business Services for Canada.
Canada Customs and Revenue Agency
Corporate Income Tax.
Internal Revenue Service
Tax Information For Businesses.
Internal Revenue Service
Tax Information For Corporations.
This information is provided without warranty of any kind. All readers wishing to take advantage of the information offered here should consult a qualified income tax preparer. In no event will Brad Howland, Howland Tax Services, or this website be liable for any damages, including lost profits, arising out of the information offered on this website.