Tax Considerations Regarding Incorporation for Start-Ups
BD&P Start-Up and Early-Stage Companies Newsletter - June 2017
John A. MacDonald and Darian Khan
Tax Considerations Regarding Incorporation for Start-Ups
By John Alex MacDonald* and Darian Khan
Incorporation is a significant step toward getting a start-up business off the ground. However, there are several questions relating to incorporation that start-ups should consider when deciding how to optimally structure their business. This article summarizes some of these questions from a tax perspective.
Whether to Hire Employees or Independent Contractors?
The distinction between employees and independent contractors is an important one from a legal standpoint. In practice it is often difficult to discern whether someone is truly an employee or independent contractor despite the label both parties have agreed to. How much control each party has over the work, who owns the tools and equipment, and how much opportunity for profit/risk of loss each party bears are just some of the factors that determine the actual relationship between the parties.
Hiring individiuals as employees or independent contractors will result in materially different tax consequences for all parties involved. For the start-up, hiring an employee is a greater administrative burden than hiring an independent contractor. Canadian law requires the employer to deduct, withhold, and remit income tax, employment insurance contributions, and Canada Pension Plan contributions on behalf of the employee. Corporate directors may even be personally liable for the corporation's failure to collect and remit these deductions.
In contrast, the law does not require withholding payments made to independent contractors. The burden to report, withhold, and remit amounts shifts from the employer to the independent contractor—but note that hiring an independent contractor means paying GST/HST for the services provided, which the independent contractor must collect and remit.
From the perspective of the potential employee/independent contractor, incorporating and providing services (that would otherwise be provided as an employee) through a corporation may result in that corporation being deemed a "personal services business". Personal services businesses face worse tax consequences than other Canadian small businesses, and therefore independent contractors should take care to avoid this classification.
How to Provide Compensation?
Early start-up operations may present challenges to cash flow—guaranteed salaries and wages can cut into funds that could otherwise be used to grow the business. One way that start-ups may deal with this issue is to align the incentives of employees and independent contractors by tying their compensation to the performance of the business.
Canadian law treats stock options and other performance-based awards (Stock Options) issued to employees favourably. For example, Stock Options issued by certain private companies are not taxed until the underlying shares are sold, and in other cases, are typically not taxed until exercised by the employee. Furthermore, while Stock Options are taxed as employment income, the employee may be entitled to claim a one-half deduction, which effectively causes the Stock Options to be taxed as capital gains. Finally, if the underlying shares appreciate in value after the Stock Options are exercised, and the taxpayer and the corporation satisfy certain requirements, the taxpayers may be able to use their lifetime capital gains exemption to offset capital gains realized on the disposition of the shares.
Stock Options are a potentially invaluable tool for deferring and minimizing taxes through performance-based compensation.
Whether to Incorporate a Personal Holding Corporation?
Individuals who are founders of start-ups (Founders) may elect to use personal holding corporations (HoldCos) for tax planning purposes. HoldCos allow Founders (or other shareholders) to defer and/or split income earned from operating corporations (OpCos).
By inserting a HoldCo between the OpCo and the Founder, the Founder may transfer certain net income from the OpCo to the HoldCo tax-free via an intercompany dividend. This limits the potential liability of the OpCo, since the funds are held by the HoldCo, which is a separate legal entity.
From the Founder's personal income tax perspective, incorporating a HoldCo also provides flexibility as to when dividends are paid and ultimately recognized in personal income. For example, if the OpCo declared and paid a dividend to a Founder directly, this amount would be included in the Founder's income and taxed as a dividend immediately. However, if the dividend were paid to a HoldCo, the dividend would not be subject to tax under certain conditoins; later, the Founder, as shareholder of the HoldCo, could pay a dividend out of the HoldCo when it is beneficial to do so. This enables a Founder to defer personal income tax to future years by leaving excess income in the HoldCo. Furthermore, subject to certain limitations, establishing one or more HoldCo's may also permit a Founder to use a combination of salary and dividends payable to him or herself, a spouse, or an adult child to minimize the overall tax burden of the family.
The tax rules around corporate dividends can be complex. Alternatively (or additionally), Founders and their families may benefit from other tax vehicles, such as family trusts.
Whether to Issue Multiple Classes of Shares?
Corporate law requires that all holders of the same class of shares be treated equally—this means that corporations must declare and pay dividends proportionately to all holders of the particular class. This requirement of equal treatment can create conflict where one shareholder would prefer to recognize dividend income in a particular fiscal period, while another shareholder or shareholders may prefer to leave money in the corporation in order to defer tax.
Similar to establishing a HoldCo—OpCo structure, authorizing and issuing multiple classes of shares within a single corporation may provide stakeholders with additional flexibility when it comes to income recognition or deferral. It allows for a corporation to issue dividends to one class of shareholders, while not paying such a dividend to holders of another class of shares. In this way, multiple classes of shares may also be used to efficiently allocate income and minimize the overall tax burden.
Whether already incorporated and producing income, or just at the planning stages, there are a number of factors, including the key ones discussed above, that start-ups should consider when deciding how to optimally structure their business.
*At the time the article was written, John A. MacDonald was an associate in BD&P's Tax Group.