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Startup Initial Tax Considerations

Tax Characteristics of Sole Proprietorship

A sole proprietor is taxed directly on the profits of a business. A proprietor may deduct from business income reasonable expenses attributable to startup operations. Individuals are currently taxed at marginal rates of up to 46.4%, while a corporation is taxed at a flat rate of about 36.1% on its first dollar of income.

Tax Characteristics of Partnerships

Partnerships, both general and limited, are not subject to taxation. Instead, each partner must take into account the partner's distributive share of each item of partnership income, gain, loss, deduction, and credit for the taxable year of the partnership that ends within or with the taxable year of the partner. The partner is accountable for these items regardless of whether there has been a distribution of money or property from the partnership. Consequently, a partner's income tax liability related to partnership transactions may exceed the distributions made to him or her in any year.

Accordingly, a distribution of money to a partner causes a recognition of gain only if the distribution exceeds the partner's basis in the partnership interest. A reduction in a partner's share of partnership liabilities is treated as a distribution of cash. Generally, no gain is recognized by a partner on a distribution of property other than money until the partner disposes of the distributed property. Instead, the partner takes a carryover tax basis in the distributed property based on the partnership's tax basis in the property (or based on the partner's basis in the partnership interest in the event of a liquidating distribution). For these purposes, however, marketable securities are treated as money; and the distribution of marketable securities will have the same effect as if the partnership distributed money to the partner.

Generally, a partner's distributive share of partnership items is determined by the partnership agreement. An allocation provided for under the partnership agreement may be reallocated by the Revenue Canada in accordance with the partner's interest in the partnership if the allocation does not have "substantial economic effect." The Revenue Canada has provided certain safe harbour rules for determining whether an allocation has substantial economic effect. The rules are based on two tests: "economic effect" and "substantiality."

An allocation will have economic effect under the regulations if, and only if, throughout the full term of the partnership, the partnership agreement provides: (1) for the determination and maintenance of the partners' capital accounts in accordance with the rules contained in the regulations; (2) upon liquidation of the partnership (or any partner's interest in the partnership), liquidating distributions must in all cases be made in accordance with the positive capital account balances of the partners; and (3) if a partner has a deficit capital account balance following the liquidation of the interest in the partnership, that partner is unconditionally obligated to restore the amount of the deficit balance to the partnership. While partners are generally allocated losses that may be incurred by the partnership, a partner's ability to deduct those losses against other items of income may be limited to the extent the partner does not have sufficient basis in the partnership interest or to the extent the partner does not have a sufficient amount at risk, and may be further limited under the passive activity loss limitation rules.

Tax Characteristics of Corporation

The income or loss of a business carried on by a corporation is both computed and subject to tax at the level of the corporation. When a corporation’s after tax income is distributed to its shareholders by the payment of dividends, these dividends are generally taxed again at the shareholders’ level. There is one very important instance in which less immediate tax will be paid if a business is carried on through a corporation rather than on an unincorporated basis – where the business is carried on by a Canadian-controlled Private Corporation (CCPC). A CCPC in Ontario is taxed at about one half the regular rate on the first $400,000 of active business income each year. If a corporation is not eligible for the small business deduction, there is still an advantage from a tax standpoint to carry on the business through a corporation rather than as a sole proprietorship or partnership. An individual proprietor or partner is taxed at marginal rates of up to 46.4%, while a corporation is taxed at a flat rate of about 36.1% on its first dollar of income. If all income earned by the corporation is paid out in the form of salary, the corporation will pay no income tax. The shareholders will thus be taxed at the same rate as if they had earned the income through a sole proprietorship or a partnership.