March 18, 2013, 5:00 am

Blog & Corporation How You Can Double Your Income

by: The Financial Blogger    Category: Blogging,Business
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Blog & Corporations; How You Can Double Your Income

 

If you haven’t already, you may be lagging right now; its tax season, so you better pack your T4s  & T5s together and fill in your tax report ;-) Mine are already sent, but it’s not because I like to be on top of my things. It’s more because I’m expecting a nice check from my friends at the Government!

 

Speaking of my friends at the Revenue Agency, Ottawa Guy, a long time reader, just sent me a quick email last week and asked two simple questions: Why did you incorporate your business? What are the advantages compared to running your blog under your own name?

 

Almost exactly five years ago, my partner and I founded our corporation. Our goal was to be able to run a true online business and make it easy to manage and to split if we would eventually disagree. But behind the protection and the simplicity, there is a huge advantage of having a corporation, no matter how big your business is…

 

The Major Advantage of Having a Corporation

 

Note: Im not a professional accountant and not providing accounting advice in this post. You must verify with a professional if your situation applies to having a corporation.

 

The major advantage of having a corporation is summarized in a single mathematic calculation:

 

(Income – Expenses) * Tax Rate

VS

Income * Tax Rate – Expenses

 

Which one do you prefer; paying your expenses before paying your taxes or after paying them? I you are a little bit familiar with accounting you guessed that the first situation happens for corporation while the second situation is for poor mortals also called tax payers ;-).

 

A corporation pays taxes only on their net profit only. This means that once the company receives its income, it can spend it all before paying any taxes. Then, once you have paid for all your expenses, you will pay a small tax rate on your net profit. All right, a small rate in Quebec is 19%… depending on which province or state you live in, this could be higher or smaller. Since my own marginal tax rate is near 50%, a 19% tax rate seems like the deal of the day for me!

 

Finding Expenses

 

Once you understand that you benefit from a tax advantage compared to regular employees, you need to find expenses that make sense. For example, I have a web company with no shipping services. How could I possibly have a car paid by the corporation? It’s pretty hard to justify it, right? And this is why my company is not paying for my RX-8 ;-).

 

However, I need a computer, internet access, a smartphone and all other electronic devices that can help me work online and test my sites. The company can then pay for these expenses since they are vital for its business model.

 

If I get back to the tax advantages, I’ll give you a real example. Let’s say I pay $70 per month for my smartphone and I earn $100 this month. Here’s what happens if I pay for my phone as a tax payer or as a corporation. I’ve set a marginal tax rate of 40% for the tax payer and a 19% tax rate for the corporation.

 

tax example

 

So the tax payer pays $34.30 more in taxes and doesn’t have enough money left to pay for the smartphone (he is short by $10). The corporation ends-up paying $5.70 in taxes because they are calculated after paying for the smartphone. Therefore, for the same transaction, the Corporation pays 5.70% in taxes out of $100 earned. I know, I’m twisting numbers here but still, the example makes it obvious that a corporation definitely has a huge benefit compared to a tax payer.

 

You obviously cannot make-up expenses and abuse this rule. If not, everybody would create their own little corporation just to switch their household expenses into corporate expenses.  However, there are several things your company will need in order to operate and they can be paid before paying taxes on the income.

 

Another way to reduce your income before paying taxes is to find losses. In our case, we can use currency losses depending on how the CAD vs USD evolves. Since we do not wish to trade currency to hedge our company, we sometimes suffer from a currency loss while exchanging USD for CAD. After all, most of our income is made in USD and most of our expenses are in CAD. This used to be a big advantage back in 2008 but it’s more an inconveniency right now ;-).

 

Amortization

 

I’m not sure if this concept exists in the United States but in Canada, you are allowed to reduce the value of an asset on your books. This has a double effect on your financial statement:

 

#1 it allows you to use this asset value reduction as an expense to reduce your profits (and pay less taxes)

 

#2 it also reduces the value of the assets on your books and therefore, will boost the capital gains to be paid upon disposition of the asset.

 

Here’s a quick example:

 

I bought a website at $10,000. Each year I can amortize the site value by 1/5 (this is an example; I’m not sure about the actual accounting rule). Therefore, I can reduce my profit by $2,000 annually according to the 1/5 amortization rule. If I sell the site after three years, the site will show on my books at a value of $4,000 (3 years * $2,000). While I saved taxes to be paid on $6,000 over the past three years, the taxable capital gain will be based on the price of the sale minus $4,000 and not the $10,000 I paid for. If I sell the site at $15,000, my taxable capital gain will be $15,000 – $4,000 = $9,000.

 

As you can see, you don’t avoid paying taxes; you simply postpone them to a later date. You can’t really avoid paying taxes, but being able to delay them for several years is definitely worth it!

 

The Tax Rate Will Always be Smaller in The Corporate World

 

Because companies create jobs and contribute greatly to the economy, their tax rate will always remain lower than that of individuals. If I hadn’t created a corporation, I would have still been able to own my blogs and make money out of them. The problem is that the benefits would have been added to my current income as a worker. Therefore, instead of paying 19%, I would have paid 49% on this income.

 

This means that for each $100 earned, I would lose a ridiculous $30 in taxes. This is a huge difference if you aad some zeros to the $100. Last year, we finished with over $40,000 in net profit. This means I would have paid an additional $12,000 in taxes as an individual compared to a corporation. Considering the accounting fees and incorporation costs, this year alone is enough to cover several years of fees!

 

I guess the final question is when should I incorporate my sideline? I think that if your sideline and day job combined together adds-up to over $50,000 per year, you should definitely consider incorporating your sideline. You will save a lot in taxes and keep the profits for yourself. This is why we didn’t wait to make money to create our corporation, we knew we were serious and we knew that we would generate over $50,000 in income per year.

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Comments

by: OttawaGuy | March 18th, 2013 (9:35 am)

Thanks TFB!

Great explanation. I have a goal this year to create more write offs for myself and get my return up by $500

I’m not sure this is completely accurate. As far as I know, you can deduct expenses in very much the same way whether your company is incorporated or not. In either case the expense is generally deductible as long as it’s related to business activity.

To see how expenses work for a non-incorporated business, see the T2125 form that you’d include with your personal T1 return. The form allows you to specify deductions for many kinds of expenses (including telephone and capital cost allowance).

And although corporate tax rates are much lower than personal tax rates, you need to consider that when you withdraw funds from the corporation in the form of a dividend, the total tax rate (corporate tax plus the tax on the dividend) becomes almost equal to the personal tax rate.

Great advice!

Do you have a post about creating your corporation?

Is it a typo when you say a combined income of $50K for both the sideline and day job? Most people will earn $50K pretty quickly and might not even earn anything with a blog for example.

What’s the amount the sideline should be to incorporate? There are cost to running a corporation which I would love to see highlighted compared with an individual.

I second Passive Income Earner’s comment.. My day job is well excess of 50k. That mean everyone sideline company should be incorporated? Why not just do a sole prop?

by: The Financial Blogger | March 18th, 2013 (7:44 pm)

@Jason,

I think you are right in an accounting perspective. If you only look at the accounting principles, there should not be any difference between an incorporation, a self employed and the business owner deriving income from his business. However, when you look at the reality, business owners with corporations are able to derive more benefits from their business than self employed.

@Savvy,

not sure I’ve done one… I might revisit a few posts and write a new one :-)

@Passive income earner,

It’s not a typo but I should have elaborate a little bit more. You are right, you may be making over 50K and not earning much from your blog. The point is that if you make over 1K/month from your sideline or your blog, it may be a good idea to create a corporation if you are already making over 50K.

@DanP,

the sole prop is more limited than a corporation in reality.

I never knew this is how the whole tax situation worked for corporations compared to a solely run company. This obviously worked well for you and is good information for anyone trying to decide whether to form a corporation. I think it would also be really helpful to post about how you went about setting up your company this way

Not quite sure what you mean by:

“when you look at the reality, business owners with corporations are able to derive more benefits from their business than self employed”

since the main premise of this post is that only corporations can deduct expenses. As I mentioned this is not the case, as sole proprietorships and partnerships can also do so. There are genuine benefits (and drawbacks) that exist with incorporation, but none of them are properly explained here.

In addition to the misinformation about deductibility of expenses and corporate tax rates, this post is riddled with many other errors. For example, your “mathematic calculation” shows two equations that are not comparable to each other: the first shows taxes paid while the second shows taxes paid (if you forget to deduct expenses) less expenses. Also, your explanation for amortization uses the straight line method while the CRA generally requires the declining balance method.

I would suggest you take this post down, or revise it after speaking with a professional accountant. This kind of misinformation could really harm people.

Great post. I’ve been thinking about this myself recently.

The blog income isn’t huge, but it’s slowly moving up in the right direction, so this is something I will consider in the years to come.

I think if the blog income hits $15-$20K per year, it might be time.

Thanks for sharing these details, again, good stuff.

Mark

Hello Jason,

my point toward deduction is the following:
throughout the years, I’ve seen many corporation owners claiming a lot more expenses than self employed. I totally agree with you that it’s wrong, but when I see those practice all over the place, I have to think that somewhere, CRA permits that. For example, several incorporations will pay for a car that the business owner will defnitely use outside his business need. Technically, he can’t but seriously, do you really think they don’t do it?

In regards to the mathematics, I’m not comparing a self employed to a corporation, I just wanted to highlight the huge tax benefit corporations have over workers. As an employee, there are tons of expenses related to your job (transportation, clothe, etc) that are not tax deductible because you don’t qualify as a self employed or a corporation.

It is true that I’m not an expert and not an accountant either. I’m sorry about the amortization example. I even mentioned that I wasn’t sure about the calculation rule for amortization. In the end, the point is the same though; you are allowed to generate “extra expenses” from amortization decreasing your revenue.

This post wasn’t intented to be a reference in accounting. I believe people should never take solely what they read on a blog to take action. There are professionals in each field and they should be used.

Thx for the clarification though.

cheers,

Mike.

@Kelly,

the tax mathematic compare a tax payer and a corporation, not a solely run company. If you run your blog as a sideline under being self employed, you will probably be able to deduct a part of your expenses too.

@My Own Advisor,

especially if you can’t deduct enough expenses and you have to add another 10K of revenues to your day job income! putting this money in a corporation will allow you to report tax overtime.

I would love to know how you built your empire! Do you have a post explaining how you got started?

[...] The Financial Blogger wrote about when to incorporate. [...]

I think, as per Jason above, that your formula is not correct. It’s implying that on unincorporated, you deduct income after taxes. I’m pretty sure that’s incorrect. Your first equation is correct for both personal and incorporation – so that in fact that’s not the reason to incorporate.

The actual scenario is a bit different, and depends on whether you spend all your money every year, because as long as money stays in the corp, then it’s taxed at a cheaper rate.

For example, you earn $100K with 10K expenses. In an incorporation, say 20% tax rate:
$100k income – $10k expenses=$90K. Pay taxes of $18k (20% of $90k) and inside the company you now have $78K.

On the personal side, if your tax rate is 45, it’s:
$100k – 10k expenses=$90K. Pay taxes of 40,500 and you have $49500 personally.

But option 3 is, you withdraw the full $90 from the incorporation so it;s now:
$100K income – 10k expenses – 90k expenses (what you withdrew)=0 taxed in the corp. In your hands $90 is taxed at 45%, so you end up with the same $49500 as not being incorporated. It only matters until there’s money inside the company to be taxed as profit. (don’t pick me apart :), it’s close to this but not exactly).

So the basic reason to incorporate is if you are earning enough money that you’re leaving money inside the company.

There are some other reasons to incorporate as well. You can decide if you want to pay EI and CPP to some extent, and that may be some ‘savings’. And you can do stuff with year end and paying yourself dividends. I don’t have specifics, I tend to trust my accountant :).

But the short answer is, incorporate if you are generating a substantial income from the business. Otherwise, don’t. If it’s making $200K, time to consider. If it’s making $30K, probably not worth the effort.

In addition to LifeInsuranceCanada.com’s points (which I agree with) I’ll elaborate on my point about the equations. The second equation:

Income * Tax Rate – Expenses

is mind-blowingly meaningless. There’s no reason that I can fathom to subtract expenses from taxes payable.

@Glenn,

thx for the additional info. You are right, the money is still in the company in my example. You will have to pay taxes if you want to hold the money under your own name.

Jason,

as I’ve mentioned in the article and this the comments: the equation is NOT about self employed Vs company it is about being an employee Vs a company. No employees can deduct their expenses to go to work.

Near the top of the article you write, “Why did you incorporate your business? What are the advantages compared to running your blog under your own name?” You seem to have changed your thesis in the comments. And while employees usually cannot deduct expenses, they usually don’t have expenses, so I’m not clear what your point is in that case.

Going back to the second equation, it does not make any sense whatsoever whether you’re talking about self-employment, employment, incorporation, or anything else. Maybe try first describing in words what you intended the equation to mean. Then substitute some example numbers and see if the result makes sense to you.

Hello Jason,

I’m preparing another article about accounting next week. I hope I’ll repair the confusion from this one…