Every small business owner at some point will ask: “Is incorporation the right move for my business?” There are a number of benefits and drawbacks based on your individual situation and business needs which need to be considered before making the decision to incorporate.
LIMITED LIABILITY: Incorporation limits the liability of a corporation’s shareholders. This means that the shareholders are not responsible for the debts of the corporation and cannot lose more than their investment into the corporation. If you’re a sole proprietor (an unincorporated business owner), your personal assets, such as your car and your house can be seized to pay the debts of the business.
Beware: Many banks and finance providers will require personal guarantees on their loans from the shareholders as a means of security. Be sure to review your loan agreements to be aware of what risks you may be subject to.
LOWER CORPORATE TAX RATES: The corporate tax rate for small businesses in Canada (currently 11% combined Federal & BC) are considerably lower than personal tax rates (20% on income in the lowest tax bracket for those in BC). This allows the business to retain more of its earnings within the company, which can be used to expand its operations.
INCOME SPLITTING: If your spouse and/or adult children own shares of the corporation, income splitting can be done by redistributing income from family members in higher tax brackets to family members with lower incomes that are taxed at a lower rate.
Beware: Be careful when paying dividends to children as any dividends paid to minors (under 18) will be taxed at the highest combined federal and BC tax rate of 53.5%.
FLEXIBILITY OF YEAR END: Incorporating gives you the flexibility to choose when your year-end will be, allowing you to pick a date that works best for your business needs (see more on selecting the ideal year-end here).
TAX PLANNING: If a shareholder’s personal tax rates are higher than the corporate tax rates, personal taxes can be deferred by delaying salary and dividend payments until a time when it is more tax advantageous to do so. So if your company has $100,000 in earnings for the year, but your personal cash needs are only $60,000, the remaining $40,000 can be left in the company and taken out at a later date, keeping you from paying the higher personal tax rates.
SALE OF THE BUSINESS: Should you ever decide to sell your company, the CRA will permit the use of the lifetime capital gains exemption, which reduces the capital gain income on the sale of the business, as well any future sales of small businesses up to a lifetime maximum ($883,384 for 2020). This exemption will apply to the sale of any shares of any qualified small business corporations. More information is available online or you can always call us.
COSTS: Incorporation is an expensive undertaking, with initial legal setup fees and recurring costs for the filing of an annual report and the preparation of a separate corporate tax return and financial statements each year. This is generally more expensive than the simple income tax filing requirements of a sole proprietorship.
COMPLICATION: Corporations come with an added amount of complexity and a lot of paperwork.
- Legal documents must be prepared and kept up to date, such as a share registry and the articles of incorporation.
- A complete set of accounting records must be maintained and a corporate tax return must be filed each year in addition to your personal tax return.
- A separate bank account will need to be set up for the company to keep personal and business finances separate (always recommended for sole proprietors too).
- The company may need to be registered for, and start filing GST, PST and WCB.
UTILIZING LOSSES: If the owner of a sole proprietorship has other sources of income besides their business (i.e. T4), they can use any losses generated by the business to offset the taxable income from their other sources, therefore reducing their overall annual personal tax bill. With a corporation, any losses generated can only be used against future earnings in the company, removing the possibility of the immediate tax relief.
LOSS OF PERSONAL TAX CREDITS: Corporations are not eligible for many of the personal tax credits that a sole proprietorship may be entitled to.
Incorporation is a big step for any business, and there are many factors to consider. Be sure to seek guidance from a Chartered Professional Accountant (and a lawyer) who can help to determine if incorporation is right for you.
**This blog is for information only and not to be used as tax advice or planning without first seeking professional advice. Information is subject to change without notice.