There comes a time when many (if not all), entrepreneurs wrestle with the decision of whether or not to incorporate. There can be many advantages to incorporation but it’s important to determine if all those advantages will actually benefit you and your business. Sometimes, it's too early to incorporate. Hopefully this blog will help you better determine your best option of business structure.
Here are 13 good reasons you might want to consider incorporating your business
- Creditor proofing of personal assets: A corporation is a separate legal entity and so corporate creditors can only go after assets owned by the corporation. (That’s why lenders will often ask for personal guarantees). By comparison, there is no limited liability when operating a sole proprietorship so personal assets such as a house or a car can be seized to pay debts of the business. Shareholders of a corporation can’t be held responsible for the debts of the corporation unless a personal guarantee has been provided.
- Lower tax rate: Privately held Canadian corporations with active income (from operating a business as opposed to passive income earned by holding investments) are taxed at a relatively low combined federal/provincial rate of tax (between 11-19%) depending on the province they operate in. These rates are lower due to the small business deduction which applies to the first $500,000 of active business income. Active business income tax rates do not generally apply to investment income or rental income. By comparison, personal tax rates can be as much as 53% at the top marginal tax rate in Canada.
- Unlimited lifespan: A sole proprietorship will cease to exist if the business owner dies whereas a corporation has an unlimited lifespan-beyond the death or departure of shareholders. That’s because a corporation is a separate legal entity and is not tied to the shareholder who created it or owns it. A corporation enjoys perpetual or continuous existence.
- Potential Tax deferral: Given the fact that corporate tax rates are much lower than personal tax rates, if funds are not required for personal use, then retaining the money in the corporation will act as a tax deferral until taken out later. Additionally, bonuses can be accrued at year end allowing for a deduction from income, but payment can be deferred for up to 6 months which might result in the income not being taxed to the shareholder/employee until the next calendar year.
- Income flexibility: Money paid out to shareholders can be paid out as salary or dividends or a combination of both. There are advantages/disadvantages to both types of income. Only salaries will provide for RRSP contribution room and CPP pensionable earnings. Dividends will attract less personal tax because dividends are not a deductible expense to the corporation. Also, if you don't need to draw out money from the corporation personally, then there is no obligation to do so.
- Capital Gains Exemption: An eventual sale of shares of a qualified small business corporation can realize a capital gains exemption of more than $800,000+. That’s a pretty huge advantage for selling shares of a corporation. A capital gains exemption does not apply to the sale of business assets (just a sale of shares)
- More options for estate & succession planning: In the event of the death of a sole proprietor, the net assets of the business will pass to the heirs, but contracts or leases may not. However, in the case of a corporation, contracts/leases & agreements should continue to exist upon the death of the shareholder. Additionally, a corporation allows for enhanced and more effective estate planning with the ability to use an estate freeze of the value of the corporation to pass on future growth to a spouse or children, thereby freezing the tax liability at the same time.
- Retirement and Health/Life Insurance benefits: A corporation can create a registered pension plan (RPP) and tax deductible group health and life insurance for yourself and for employees which could include family members. Establishing a pension plan within the corporation may provide higher retirement benefits than those available from an RRSP plan. Premiums paid by a corporation for a private health insurance plan are deductible by the corporation and are not considered to be a taxable benefit to employees. That means these premiums are paid pretax for the corporation rather than after tax by the individual. That’s good tax optimization.
Year end flexibility: An incorporated business can have any fiscal year end it choses whereas a sole proprietorship must have a December 31st year end. Choosing a non-December 31st year end may coincide better with business activity or inventory peaks.
Income splitting: Incorporation allows for a spouse or adult children to be shareholders in the corporation and receive dividends to be taxed in their hands. A rule change in 2018, requires those family shareholders to be active participants in the corporation; otherwise dividends paid to those shareholders will be taxed at the top personal tax rate, negating the benefit of income splitting with dividends. The corporation can also employ family members as long as remuneration is reasonable for the work performed.
Multiple owners: A corporation is the best type of business structure to use where multiple owners will own a business. Transferring shares of a corporation is a lot easier than binding other owners to the partnership debts of the other owners.
Protecting your company name: The name of the corporation will be reserved specifically for the company within the jurisdiction of registration upon incorporation which is the result of a rather rigorous name search. Such is not the case for sole proprietorships or general partnerships.
Easier access to capital: Raising capital for growth and expansion is generally easier for a corporation since a corporation can issue stock. Corporations generally also have better access to lenders who prefer a business be incorporated even if they still require a personal guarantee.
While it may seem that that the list of advantages of incorporation noted above are too many to not take advantage of, there are some disadvantages and qualifiers that need to be considered as well when considering incorporation.
Here are 5 good reasons you may not want to incorporate or wait to incorporate:
- Additional accounting fees: Because a corporation is a separate legal entity, an annual corporate tax is required to be filed. Costs will vary depending on whether an audited financial return is needed or not. A simple corporate tax return will cost $500 or less but the financial statement fee can vary depending on the complexity and the assurance level required.
- Additional legal fees: There is a one-time legal cost to incorporation which may vary between $1,100 and $3,000 depending on the complexity of the structure and whether it is a Provincial or Federal incorporation. In order to maintain the corporation, it’s also important to keep the minute book up to date and also the shareholder registers.
- Lower tax rates may not apply: Lower tax rates and a deferral of tax will really only apply if you are earning more income than you need to withdraw from your corporation for personal use and will retain that money in the corporation. If you withdraw such tht there is very little retained earnings in the corporatin then the tax advantage is minimal. The tax advantage is mainly a deferral of taxes until the profits are paid out to the shareholder.
- Less flexibility with losses: Losses can occur in any year but most especially during the startup phase. However, losses incurred by a corporation can only be carried forward or back to reduce corporate profit from other years; they do not flow through to the shareholders to be offset against other personal income. By comparison, losses incurred by a sole proprietor can be offset against other types of personal income. That’s why, especially in the start-up stage of a business, it’s generally advisable to defer incorporation until after the business is profitable, unless there are potentially large liability issues.
- Limited liability may not be limited: Limiting personal liability by incorporating may be deemed irrelevant if personal guarantees or credit agreements are required to be given to corporate lenders or landlords.
In summary, there can be many benefits and tax advantages to incorporation but determining whethera corporation is right for your business is key. Generally, the higher the net income of your unincorporated business, the more advantageous it maybe to incorporate. On the other hand, if you are a sole proprietor with little at risk and you are earning just enough to live on, the additional cost of incorporation may not make sense.
Be sure to reach out to your accountant to review if incorporation makes sense for your business.