For some of you, the prospects of a decent crop along
with old crop deferrals may be causing you to reconsider the option of
incorporating in order to defer tax. In our office we are often asked to
quantify the tax deferral benefits in order to more clearly communicate
the potential benefits of incorporation.
There are two main deferrals that can be realized by incorporating.
Initial tax deferral upon incorporation
To illustrate the initial tax deferral, letís look at the balance sheet
of our sample farm that is provided in table 1. What is most noticeable
is the difference between the fair market value and adjusted cost base
of the farmland. It would appear that the farm has been rolled forward
from one previous generation to the next at its original purchase price.
By incorporating, our farmer could transfer land to his farming company
and in the process realize a capital gain of $500,000. Provided that the
farmer has access to the $500,000 capital gains exemption, the company
would issue in exchange for the farmland, a $500,000 promissory note
that the farmer could withdraw tax free.
The creation of this promissory note enables the farmer to replace his
salary or dividend income from his farm corporation with tax free note
withdrawal which creates what we call an initial tax deferral.
Annual tax deferral
Canadian controlled private corporations pay a much reduced rate of tax
on the first $250,000 of active business income. This lower tax rate
between 17% and 19% in most provinces Ė leaves the incorporated business
with more after-tax dollars, which can be either reinvested back into
the business or paid to its shareholders as a salary or dividend.
If you have a corporation and you do not withdraw all of your company
profits personally in the form of a salary or dividend but rather
reinvest these funds back into your business by either acquiring assets
or paying down debt then you will experience what is known as annual tax
deferral. By leaving funds in your company, you are essentially
deferring the personal income taxes that would have been triggered on
these funds had they been paid to you in the form of a salary or
go back to our sample farm and try and quantify the annual tax deferral.
Letís assume that the farm generates a yearly net income of $60,000.
After making its $10,000 principal loan payment and $10,000 in capital
purchases, all remaining profits are paid out to either the proprietor
or shareholder. In table 2, we have Mr. A, who is not incorporated.
After income taxes and loan payments, Mr. A is left with $21,266 in his
In table 3, we have Mr. B, who runs the same farm but through a
corporation. For Mr. B after income taxes and loan payments he is left
with $25,216 in his pocket. The difference is our annual tax deferral of
We can prove the annual tax deferral by applying the formula in table 4.
Since the farmís worth or equity rose by $20,000 and Mr. Aís marginal
tax rate is approximately 35% we recalculate our annual tax deferral of
Quantifying the initial and annual tax deferral is only one small part
of the incorporation decision. For this reason, anyone considering
incorporation should review their own unique circumstances with their
own professional advisors. Hopefully, this column will provide a better
understanding of tax deferral.