Incorporation
There is really only one type of corporation in Canada, though we often refer to both public and private corporations. The former is owned by a broad range of individuals and is often traded on a stock market. Private corporations, rather, are usually owned by a limited number of shareholders, and the shares are not actively traded. This is the type of corporation discussed in this article. We also use the terms “operating companies” and “holding companies.” There is no fundamental difference between these two entities; they are just used for different purposes.

Operating Companies
One of the more common questions accountants get from clients is whether they should establish a corporation. In rare circumstances, an individual wishes to enter into a business relationship with another entity with a condition being that they incorporate. In this case, liability and tax considerations are secondary and the decision is based more on the contractual requirements. Otherwise, the answer is generally focused on liability protection and tax savings considerations, both of which are addressed below.
The most common reason given for incorporation from a legal perspective is liability protection. There are those who claim that this is not relevant since their business is not exposed to legal liability or they are convinced that they have sufficient insurance. In all honesty, we are becoming a more litigious culture and even low-risk businesses are exposed to liability. Insurance policies including errors and omission coverage are still subject to limits, and most policies have complex clauses that allow insurers to deny coverage. A corporate structure will protect a business owner’s personal assets, including their home and investments, from business liability. We usually refer clients to their lawyer and insurance agent for liability discussions. Suffice it to say that the owner of any business dealing with the public, such as a restaurant, should strongly consider incorporation.
The second reason to incorporate is for tax savings. There are a few ways to save tax by incorporation. The most common one is to earn income within a corporation and leave the after-tax profits in the company. Nova Scotia’s corporate tax rate is currently 11.5%. This leaves 88 cent dollars saved in the corporation, and no personal tax is payable until such time as the shareholders remove funds (income) from the company. At this point, there is an additional (personal) tax payable of between 15% and close to 40% for dividends. The result is 60-72 cent dollars in your personal hands. Presumably, funds held in the company will eventually be paid out but delaying withdrawal can result in personal income tax deferral and, if done over many years, less overall personal tax payable by taking advantage of lower tax rate brackets. Generally speaking, there is little tax incentive to incorporate a business unless it earns more profit than is needed by the shareholders and the tax deferral can be realized.
While leaving funds in the company is an excellent way to defer personal tax, it is not always practical since the shareholders often require these funds. An option more relevant in the past was to split income across multiple shareholders, and this was referred to as income splitting. Recent changes by CRA now limit unrestricted income splitting to those who are active in the business. Being active is taken to mean at least 20 hours per week. Failing this, only amounts reasonably earned by inactive shareholders can be paid. The rules on this are new and untested in courts, but presumably pay rates would be limited to a fair market rate that would be paid to an unrelated employee. There is also a grandfather clause for family members who were active in the business for at least five years in the past. This would accommodate, for example, a parent who worked in the business for five or more years but subsequently left it for child-rearing purposes. Where income splitting is allowed, it is an excellent way to “double up” on the personal income brackets. The principle is that two people earning say $70,000 each will pay far less personal tax than one person earning say $140,000 while the other has no income.
A final consideration for incorporation is the type of business. The above considerations apply primarily to corporations operating an active business. These are usually referred to as operating companies (Opcos). Examples include restaurants, retail stores, consulting practices, medical services, and even accountants. Investment activities, including rental properties, are not considered active business income. It rarely makes sense to establish a holding company in which to invest unless an active business corporation already exists.

Holding Companies
A holding company (Holdco) is one that is used primarily for investing activities. Examples of investments held include rental properties, mutual funds, and stocks. Income generated from these assets is referred to as passive income, and it is often taxed at higher rates. Tax planning often requires the payment of taxable dividends to shareholders to keep the corporate tax rates payable below 50%. This is the main reason why it does not make tax sense (liability issues aside) to establish a Holdco to which shareholders would lend money for investing. Put another way, investing personal cash in personal investment accounts makes more sense than using a Holdco to invest personal funds. We would recommend consulting with your lawyer regarding liability considerations.
When does a Holdco make sense? The most common example is when there is an existing active business corporation in which funds have been retained to defer personal tax. Just as we establish an Opco to protect the personal assets of the shareholders, we establish a Holdco to which we can move excess cash out of the Opco, thus protecting it from business liability. In this way, we now have a corporation to operate the active business and a Holdco to store excess cash and use it for retirement planning purposes. Using a Holdco can also enable the Opco’s shareholders to sell their shares on a tax-free basis.

Capital Gains on the Sale of a Business
It is often said that business owners operate a business to earn a living but own a business to make a profit. The government has encouraged individuals to build small businesses since they are a major driver of the economy. As an incentive, the government allows shareholders of active businesses to sell the shares of their business and claim all or a portion of the sale as a tax-free sale. This is achieved by claiming the capital gains exemption on the sale of a qualified small business corporation (QSBC). There are a number of criteria that must be met, but most active businesses qualify. Holdcos would generally not qualify as there is a requirement that the corporation hold mostly active business assets and not cash and investments. In order to qualify, the shareholders must be individuals or beneficiaries of a family trust. This is an important consideration when setting up a corporate structure.

Family Trusts
We have already discussed the use of a Holdco as a vehicle for storing excess cash and thus for retirement planning purposes. The easiest way to achieve this is to have the shares of the Opco held directly by the Holdco—often referred to as a “stack” structure. Dividends are declared and paid from the Opco to the Holdco, with any personal cash requirements paid from either company to the individual shareholders. The issue is that in order to move money from an Opco to a Holdco, the Holdco must own the common shares of the Opco. However, the capital gains exemption for QSBC shares is only available to individuals. A Holdco can’t claim a tax-free QSBC share sale. So we use the stack structure only in instances where it is unlikely that the Opco can ever be sold for a gain. A consulting practice is a good example of this.
Where an Opco can be sold for a gain, we will need it to either be owned by individual shareholders or by a family trust. Individual ownership prevents the use of a Holdco. In this case, an Opco is best owned by the trust. Money can then flow from the Opco to the Holdco via the trust. Individual shareholders can then receive money either from the Opco or the Holdco directly or from the trust. If the Opco shares are sold, the trust can recognize the gain but flow it through to individual shareholders, thus allowing them to claim the capital gains exemption for QSBC shares.  A trust does complicate the movement of funds and adds additional annual accounting costs, but the potential to realize a tax-free capital gain on the ultimate sale of a QSBC makes it desirable.

Conclusion
The design of a corporate structure is complex and differs depending on the nature of the business and the shareholders involved. It is important to consult with a lawyer and an accountant to determine the best fit in your case, with consideration given to liability protection, tax minimizing, and fees.