A short, practical explainer by Bob Gauvreau on the differences and interactions between business taxes and personal taxes. He contrasts separate corporate tax filing with sole proprietor/partnership reporting on personal returns, explains treatment of wages vs dividends, and recommends retaining earnings inside a corporation to benefit from lower corporate tax rates (noting 12.2% on the first $500,000).
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So let's talk about the difference between business taxes and personal taxes. Now, this could be a longer conversation, but I'm going to try and keep this as simple as possible. If you have a business that is a corporation, they have a separate, they are a separate legal entity and they have a separate requirement to file taxes on their own behalf. You as an individual are required to pay taxes and file and submit taxes. If you owe money to the government at the end of the year, people normally ask, well, how do we know if we owe money to the government? You fill out your taxes. At that point, we would identify if you owe anything and we would have to submit taxes on your behalf. Now, if you are a sole proprietor or a partner, the only taxes you need to file are on your personal tax return. Any proprietor or partnership income gets filed and included on there. Again, if you have a corporation, separate entity, separate filing. Let's talk about the difference between the two. So as a business, you pay tax on your business income. In your business income, you can have expenses such as payroll or wages to yourself. If that's the case, the business gets a deduction for that. If we're doing it that way, you've got to claim the wage on your personal tax return and pay tax on that wage on your personal tax return. On the other side, back to the business, if your business doesn't pay a wage, but it pays you as a shareholder as a dividend, the business does not get a deduction for that. It does have to file its taxes. Pays tax before dividend distributions. And then if you're claiming that dividend distribution, you do have to pay tax on that over here. As an individual. Now it's at a lesser reduced tax rate because the business has already paid more upfront. So in essence, there's going to be a combination between the two. You're looking at both of them and saying, I'm going to have to pay tax on my business based on how much my business made. I'm going to have to pay tax personally based on how much my proprietorship, my partnership made or how much I pulled from my company if I have a corporation. So we want to look at the two of those and say, how do we come up with the most optimized tax planning arrangement for you to keep the most amount of money? And I can tell you upfront, most optimized way to save money is to earn money in a business structure. Corporation tax rate 12.2% for the first $500,000. You say you make all your money in there and you leave as much as you possibly can in there. You avoid the personal tax on taking the money out and you reinvest all your corporate money and build an investment portfolio or reinvest in your business to continue to add value there. So the difference business taxes, personal taxes, they work together. They tend to be aligned in many cases. But if you want to avoid some of that tax, stop taking the money out, leave it in your business, and let your business pay business tax.
