The Chicken and Egg of Incorporation
How legal formalities can have a big impact on taxes
Many advisors who sell life insurance conduct their practice through a corporation to take advantage of the myriad tax advantages that incorporation provides. This includes the ability to access the preferential small business tax rate on the first $500,000 of active business income as well as the ability to defer personal tax on any investment income earned by leaving it in the corporation until it's paid out as a dividend. With a spouse or kids over 18, income splitting can also be accomplished if they own shares in the corporation for which dividends are being paid.
Finally, upon ultimate sale, you may be able to take advantage of the $750,000 lifetime capital gains exemption on the sale of your shares, assuming the corporation qualifies as a small business corporation at the time of sale.
A recent tax case (Langille v. The Queen, 2009 TCC 398) involved Eric Langille, an insurance broker from Nova Scotia, who entered the business around 1989 after retiring from full-time farming activities.
Ten years later, Mr. Langille left his employment with a major insurance company to form his own insurance brokerage, which was established as a sole proprietorship named Maritime Financial Services (MFS). MFS was an independent brokerage that placed policies with various major insurance companies.
In the fall of 2001, Mr. Langille decided he would like to incorporate his business. In October, he consulted the accounting firm of Grant Thornton for advice on whether and how to incorporate. Mr. Langille decided to proceed with the incorporation and Grant Thornton advised his law firm to incorporate on Friday, November 16, 2001.
Maritimes Financial Services Incorporated (MFSI) was duly incorporated as a Nova Scotia company on Monday, November 19. Using section 85 of the Income Tax Act to accomplish a tax-free rollover, Mr. Langille transferred his sole proprietorship, MFS, to MFSI on November 22, 2001.
While on the surface everything appeared to be in order, it turned out that the rush to incorporate was motivated by two large commission cheques on the sale of one Transamerica Life policy, totalling about $150,000, which Mr. Langille wanted to have taxed in his corporation.
The policy and the first commission cheque were issued on November 9. It was cashed and deposited in MFS' RBC Royal Bank account on November 14. The second commission cheque was deposited to the account two days later.
Mr. Langille argued that the commission income was not his but properly that of MFSI since it was his “intention” to have had the incorporation and business transfer completed before the cheques were cashed (i.e., the week of November 12), thus allowing the two commission cheques to be reported as income to his corporation.
The CRA reassessed him and included those amounts in his 2001 personal income rather than in MFSI’s corporate income as the CRA’s position was that “the services were performed by him carrying on business as MFS and the cheques were received and cashed by him operating as MFS before MFSI was even incorporated.”
In court, Mr. Langille argued that the business transfer “was sufficiently advanced with Grant Thornton” before the cheques were deposited and thus they could be treated as MFSI's commission income.
Not surprisingly, the judge had some difficulty with this argument for a number of reasons. In particular, even though Mr. Langille did not include the commission amounts in his personal income for 2001, he did personally deduct related expenses, including “significant sub-commissions” that he paid to other brokers who assisted in the sale of the policy. Both Mr. Langille and Grant Thornton claimed this was an oversight.
Another concern the judge had was that even after the date of formal incorporation, MFSI continued to use the personal business bank account opened by MFS as opposed to a corporate account for MFSI.
The judge therefore concluded that the income on those two policies was indeed properly taxable in Mr. Langille’s hands. As the judge wrote, “I cannot accept that in a case such as this the taxpayer's intention is relevant to applying the income tax law to the actual events and transactions that occurred … if MFSI was not incorporated until November 19 … MFSI as a distinct person-like legal entity could not have earned any income before it came into being. This type of retroactive taxation would be like trying to assess a natural person for tax on income generated while the person was still in the womb or a mere glint in someone's eye.”
Advisors considering the tax advantages of incorporation would be well advised to ensure that the legal formalities of establishing the corporation are met before attempting to use the corporation for any tax benefits.