Real Estate Incorporation – It’s for all Real Estate Agents – but it’s not…
Incorporation for Real Estate agents has become a buzz word with advertisements touting guaranteed tax savings for Personal Real Estate Corporations [PREC]. However, before making any major business decisions, I believe it is always prudent to fully understand the merits and potential risks or downsides.
Incorporation has become as easy as 1-2-3 with many websites that allow quick incorporation for anyone looking to start a new business.
Many small businesses have incorporated because an owner was ill-advised that incorporating was a sure way of paying a lower tax.
Without fully understanding the legal aspects, reporting requirements, and record-keeping obligations, owners could end up paying additional costs in legal and accounting fees.
They can also end up having unforeseen adverse tax exposures if significant transaction aren’t carefully planned in advance. A clear example of this is moving funds out from a company without considering the personal tax implications.
Incorporation, when planned and implemented properly, can have many benefits and can be a very effective structure for operating a business.
For a more detailed discussion of other considerations for incorporating, check out our article on incorporation.
It is true that Canadian Controlled Private Corporations [CCPC] pay a low rate of income tax. At the time of writing this article, the current combined corporate tax rate for a CCPC eligible for the small business deduction is 12.2% on the first $500,000 of taxable income.
Compare this tax rate, with the average person in Ontario making $75,000 a year, who pays an average tax rate of 20.7%. It would seem that incorporating is an easy ‘no-brainer’ decision. Using this logic, every businessperson should go online and incorporate to start saving on tax.
What this overly simplified analysis does not take into account, is that the Canadian tax system is an integrated system. In simple terms, income earned in a corporation is taxed when drawn out of the company by way of salary or dividend. These funds will then be taxed again on an individual’s personal tax return. When this combined tax is added up, it will generally be equal to the same amount of tax as if the individual earned the income directly as a sole proprietor.
For this reason, an individual that owns a company and requires all their profit earned in the company to be paid out to them personally will be no better off than if they were to operate as a sole proprietor. In fact, the person will likely be worse off as the accounting and legal fees to maintain a corporation are higher.
If the owner of the company does not require all the funds, then there is potential for a significant tax deferral by leaving funds within the company.
Advantage of incorporation
There are many theoretical advantages for a Real Estate Agent to incorporate.
Googling Real Estate Agent Incorporation will bring up many sites proclaiming benefits such as:
- Lifetime capital gains deduction
- Income splitting
- Name recognition etc.
These are all features of a corporation, but are they really relevant for the average PREC?
Lifetime Capital Gains Deduction
When an owner sells the shares of a Qualified Small Business Corporation, if certain conditions are met, a lifetime capital gain of up to $883,384 (2020 rate), is received tax free. This offers a very significant tax saving and an incentive for businesses to incorporate. However, for this to be applicable, you must have a willing buyer for your corporation. They must also be willing to purchase the shares of your corporation.
Often in the case of professional services, the main asset being purchased is a client listing. It is also often on a case-by-case basis whether the purchaser will actually buy the shares of the corporation or purchase the intangible assets. In the event where the assets are purchased directly, the lifetime capital gains exemption is not available.
The lifetime capital gains exemption is certainly a powerful tax planning tool. It is relevant for owners that have built up a significant client base to which there is a willing buyer for the shares. While this exemption is relevant in some circumstances, it shouldn’t be used as a single motivator in the decision to incorporate.
Unlike a regular corporation, a PREC can only have one registrant that owns all the voting equity shares. Also, non-voting shares may be held by family members. However, in 2018 the Federal Government released the Tax on Split Income Rules. In the context of a PREC, in most instances, these rules severely diminish the income splitting opportunities.
The ability to reduce overall family taxes by streaming dividends to a spouse not actively involved in the business is no longer a viable option in most cases. So there may be some tax benefits to having a spouse as a shareholder of the PREC, but the situations are limited in scope.
Trading through a corporation may offer the prestige of appearing to have greater status. However, a PREC must not represent to the public that the corporation carries on the business of trading in real estate.
The most attractive feature for Real Estate Agent Incorporation is through tax deferral. Tax deferral is relevant in the case where the owner earns more than their personal spending requirements. This means that excess funds can be left in the company and it defers the personal taxation.
This allows the corporation to invest the surplus of funds that have been taxed at the low rate of 12.2% back into the company. This means that the company will have more money to invest in growing the business or to make investments allowable by PREC regulations.
It also allows the owner to smooth out their personal income. Owners can trickle out income from their corporation to manage the level of personal tax they pay. An individual’s taxation is based on a sliding scale, i.e. the more one earns personally in a year, the higher rate of tax they pay on each dollar earned.
Therefore, a PREC will allow the owner to defer personal tax. This means in years where sales are strong, the excess funds can be left in the corporation and drawn out at a later date when individual income is lower. This type of planning, when done correctly, can represent a real tax saving rather than simply a deferral.
Stay tuned for part 2 of this article! We will explore the everyday practical considerations of incorporation. This includes, legal responsibilities, record keeping, and what to look for in a good practitioner.