Should you incorporate your small business? Every business owner should give consideration whether or not to incorporate their business. The outcome of this decision is highly dependent on the unique details of each business owner’s situation and should be discussed with a professional. The form of a business isn’t irreversible; the legal structure of a business can be changed as it grows. A common scenario is for small businesses to start out as a sole proprietorship or partnership and become incorporated at a later date when the business has grown.
Below is a discussion of some of the general advantages and also potential drawbacks to incorporating a business. For a comprehensive discussion tailored to your specific situation please contact us at Edward & Manning LLP.
1. Limited Liability
The most well-known feature of incorporation is the limited liability feature. Unlike a sole proprietorship, where the business owner assumes all the liability of the business’s operations, when a business becomes incorporated, an individual shareholder’s liability is limited to the amount he or she has invested in the company. If you’re a sole proprietor, your personal assets, such as your house and car can be seized to pay the debts of your business; as a shareholder in a corporation, you can’t be held responsible for the debts of the corporation unless you’ve given a personal guarantee.
On the other hand, a corporation has the same rights as an individual; a corporation can own property, carry on business, incur liabilities and sue or be sued.
2. Corporations Carry On
Another advantage of incorporating is continuance. Unlike a sole proprietorship, a corporation has an unlimited life span; the corporation will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes.
3. Increased Flexibility to Raise Capital
Corporations also have more flexible options as to how they might raise external capital, which may make it easier for your business to grow and develop. While corporations can borrow and incur debt like any sole proprietorship, they can also sell shares and raise equity capital, a big advantage as equity generally does not have to be repaid and incurs no interest. Of course, by issuing shares, you are reducing your percentage of ownership in the company.
4. Increased Business Credibility
Having a Ltd., Inc. or Corp. as part of your company’s name may increase the credibility of your business, as people often perceive corporations as being more stable and established than unincorporated businesses. If you’re a contractor, you may also find that some companies will only do business with incorporated companies, because of liability issues.
To begin it must be understood that corporations are taxed differently than other legal forms of business. The most obvious tax change is that as a corporation is a legal entity and therefore the corporation is taxed separately from the individual.
1. Income Control
If you incorporate your small business, you can determine when you personally receive income. This is a real tax advantage as becoming incorporated gives you the option of leaving earnings within the corporation which can result in an income tax deferral. Corporate income is generally taxed at lower tax rate therefore you may be able to realize tax savings by deferring the receipt of corporate income at a personal level until a later time.
2. Income Splitting
Another tax advantage of incorporating is income splitting. Corporations pay dividends to their shareholders from the company’s earnings. A shareholder does not have to be actively involved in the corporation’s business activities to receive dividends. Your spouse and/or your children could be shareholders in your corporation, giving you the opportunity to distribute income from family members in higher tax brackets to family members with lower incomes that are taxed at a lower rate.
3. Income Receipt Flexibility
Another benefit to incorporation is the flexibility to determine how you get paid. As a sole proprietor, all business income must be included in your personal tax return in the year it is earned as business income. If you have incorporated your business, you can choose to take withdraw earnings via salary or by way of a dividend. In most cases, a dividend of approximately $44,000 can be received tax free (assuming no other income is earned in the year). Of course, taxes will have been paid by the corporation, but at a lower marginal rate. There can be drawbacks to earning only dividend income in the year as it is not considered to be “earned income”; certain personal taxation benefits are available only to a taxpayer with earned income in the year. For example, without earned income your RRSP contribution room does not increase, you will not be paying CPP, and child care expenses (if applicable) may not be deductible. This decision is not permanent; you can always change the way you are paid the following year. Please talk to a professional before making the salary/dividend decision.
4. The Small Business Tax Deduction
The biggest corporate tax advantage is for those that qualify as a Canadian-controlled private corporation (CCPC). CCPC’s are eligible for the small business deduction. The principal objective of this deduction is to reduce the corporate tax rate on active business income down to 20%. The small business deduction applies to the first $500,000 of active business income.
There are very specific criteria used to determine whether a corporation would qualify as a CCPC. Should your corporation qualify, there are other corporate tax advantages available to CCPC’s as they are also entitled to:
- an additional month to pay the balance of most corporate taxes payable for the year;
- enhanced investment tax credits, which may be fully refundable, for their qualified expenditures on scientific research and experimental development (SR&ED);
- shareholder entitlement to the capital gains exemption on the disposition of qualified small business corporation (QSBC) shares.
While there are numerous advantages to incorporating a small business, there are also some potential drawbacks that need to be considered when deciding to incorporate a business.
1. Another Tax Return
When you incorporate your small business, you’ll have to file two tax returns each year, one for your personal income, and one for the corporation.
2. Increased Paperwork
There can be more paperwork involved in maintaining a corporation than a sole proprietorship or partnership. Corporations, for example, maintain a minute book, containing the corporate bylaws and minutes from corporate meetings. Other corporate documents, that must be kept up to date at all times, include the register of directors, the share register, and the transfer register.
3. Use of Tax Losses
A corporation does not have the same flexibility in handling business losses as a sole proprietorship or a partnership. As a sole proprietor, if your business experiences operating losses, you could use these to reduce other types of personal income in the year the losses occur. In a corporation, however, these losses can only be carried forward or back to reduce the corporation’s income from other years.
Please Note: This article is not intended to establish professional advice. Specific professional advice should be obtained prior to the implementation of any suggestions contained in this article. We would be happy to discuss your unique situation directly with you to determine how the above information could best be of benefit to you.