Guidance from Tax Partners Accountants: a York Region accounting firm specializing in privately-held and owner-managed businesses.
There is one question that is often top of mind when we speak with entrepreneurs who come to Tax Partners for business advisory. That question is: “Should I incorporate my business?”
If you are a small business owner confronted with the decision of whether or not to incorporate your business, then this article is for you.
A Key Consideration:
If you are a sole proprietor with little risk and require all the cash generated by your business to fund your personal lifestyle, then the additional costs of incorporating may not be economical. But as your business grows, so do the advantages of incorporating. Let’s begin with the main advantages of incorporating a business.
The Pros for Incorporating Your Business:
Insulate your business risk
If you are using corporate debt to finance growth, incorporation means that the shareholder (you) cannot be held responsible for that debt (subject to certain exceptions). Once incorporated, the shareholder’s liability is limited to the amount they have invested in the company. Still, here are some examples of when a shareholder might be held personally liable:
- Personally guaranteed loans
- Government tax obligations such as unpaid GST/HST and employee payroll deductions
- Environmental damages
- Professional negligence (for regulated professions like Dentists, Doctors, Lawyers)
Protect your personal assets
Should anything go wrong, incorporation protects your personal assets from creditors or legal action. As a corporation, only the assets inside the corporation are at risk in a lawsuit; while the personal assets of the shareholder (such as one’s home, possessions or car) are protected (subject to the exceptions listed above).
Raise money for your venture
Corporations provide greater flexibility to raise funds as they have the ability to issue shares and debt to investors. Please note that a lawyer needs to be consulted regarding relevant securities legislations as to who can invest in a private company. Generally speaking, only family, close personal friends, and accredited investors (high net worth individuals) can invest in a private company without requiring that a company issue a prospectus.
Benefit from a lower tax rate
At the date of this article, the tax rate of incorporated businesses (in Ontario) is calculated at a rate of 15.5% on the first $500,000 of active business income and 26.5% thereafter. That is much lower than the 49.53%* a sole proprietor would pay on personal income over $220,000. *Note: It will be 53.53% starting in 2016.
Get tax efficient
You can choose the most tax efficient way to pay yourself with dividends, salary or a combination of the two. If a family member is a shareholder, you can use dividends to split income with your family (subject to certain conditions). Note that a shareholder does not have to be actively involved in the business to receive a dividend.
Invest in your business
If you do not need all the business income for your personal needs, you can retain the earnings and reinvestment them in the business, thereby deferring personal taxes.
Benefit from capital gains exemptions
Currently a lifetime capital gains exemption of $813,600 is available on the disposition of qualified small business corporation (QSBC) shares. Generally speaking, if you have an active Canadian business it may be possible to qualify for this exemption. The specific criteria for receiving this exemption is beyond the scope of this article, but Tax Partners can provide business advisory for this matter.
Estate planning options and business succession
Plan your estate more effectively. You can “freeze” the value of a corporation today and pass on future growth to your spouse or children. This allows you to fix your tax liability associated with the corporation at death and pass on the business to family or business associates.
Alternatively, here are some of the disadvantages of incorporating your business.
The Cons of Incorporating Your Business:
The cost to incorporate a business can be roughly split into three categories:
- Fees to determine the appropriate ownership structure. These fees vary greatly from business to business.
- Legal fees to obtain articles of incorporation. The legal fees to obtain articles of incorporation from a mid-size law firm could be approximately $3,000 (as of November 2019).
- Fees associated with transferring assets to the corporation. These fees vary greatly from business to business.
Annual costs and requirements
In addition to filing your T1 personal income tax return, if your business is incorporated, you will now have to file the following additional tax returns:
- A T2 corporate income tax return for the company
- If you have employees, a T4 return is required to report any wages, commissions, etc. to employees
- If the corporation pays a dividend, a T5 return needs to be filed.
As a sole proprietor, any losses incurred by your business can be offset against other personal income. In comparison, losses incurred by a corporation cannot be offset against personal income and are in effect “trapped” in the corporation. The losses can be carried forward and applied against income earned in future years by the corporation, or against income earned in the three previous years by the corporation. As a result, it is generally advisable to incorporate after any start-up losses are incurred.
While this article provides general business and tax advice, it may not be the best advice for your situation. We strongly recommend that you meet with a Tax Partners advisor for personalized advice, that will provide you with the greatest benefit.