The reasons you should, shouldn’t and the cost.
Why you should incorporate your small business?
Limited liability (except personal guarantees and director liabilities)
- If you are a sole proprietor, all of the risks of the business are also your own personal risks. If the business gets sued, you get sued – All of your personal assets are at risk.
- A corporation is the creation of a separate legal entity. As a separate entity it can enter into contracts, open bank accounts, own assets, hire employees and it can sue or be sued. Once a corporation has been formed, individuals (or other corporations) can subscribe for shares. These shares represent fractional ownership of the new corporation.
- A shareholder’s liability is limited to the amount that they paid for their shares. Generally, with the establishment of a new corporation the price paid for the shares is a small nominal amount.
Most financial institutions will not lend money to a small corporation without the “personal guarantee” of the shareholders. This means that you will still be personally liable to the extent of the amount of the loan.
If you are a director of the corporation (which is usually the case for a new small corporation) you still have personally liability for a smaller subset of faults:
- Payment of payroll taxes and HST
- Unpaid wages of employees and vacation pay
- Fiduciary duty – requirement to act in the best interests of the organization. (Sexual Harassment liabilities are one example)
- Environmental Disasters
Lives beyond the owner (contracts/leases, etc.)
- When the owner of a sole proprietorship dies, all of her assets will be distributed according to her Will. But what about all of her contracts, leases, agreements, employees?
- A corporation never dies. While it can be wound-up based on the intention of the shareholders, it doesn’t die suddenly of natural causes. This means that all of the contracts and agreements with suppliers, clients and employees continue.
Pay less tax
- This is normally the primary consideration for a sole proprietor to turn their business into a corporation. A sole proprietor pays tax on the net income of the business (revenue minus expenses) on his own personal tax return. This means that he is subject to the same marginal tax rates as an employee. This can be as a high as 53% in Ontario for net income over $250,000.
- A corporation pays 12.5% in Ontario on the first $500,000 of net income in the corporation. Above $500,000 the tax rate is 26.5%. With lower tax rates, more money stays in the business and can be re-invested to promote further growth.
- The greater retained earnings can also be invested passively. With more money retained, you have more money to invest. (NB. There are new rules that cause a small business to lose its low tax rate of 12.5%, if passive income exceeds $50,000)
Capital gains exemption
- When qualifying1 shares of a small business are sold, there is no tax payable on the first $866,912 of gain. This exemption limit is indexed every year to inflation.
- Sole proprietors that sell their business do not enjoy this exemption.
Private Health Services Plans
- Most small businesses obtain protection for the owner in the form of medical/dental/vision insurance. There are limits on the deductibility of this insurance for sole proprietors. They cannot self-insure and there is a $ limit for the premiums that are deductible if insurance is purchased.
- Corporations can self-insure the risks of its employees, including the owner. There is also no limit to the deduction for insurance premiums.
- Income-Splitting is the practice of shifting income from someone in high tax bracket to someone in a lower tax bracket.
- A sole proprietor can pay a salary to a spouse for duties performed as a method of splitting income.
- For corporations, recent legislation has curtailed many of the previous opportunities beyond the payment of salary to spouses and children for duties performed.
- There are still some income splitting opportunities that remain:
- You can pay dividends to a spouse that provided funding or personal guarantees to the business. For example, if you borrowed money, with a co-owned principal residence as the collateral, the spouse is entitled to a reasonable share of profit.
- You can split income with yourself. By choosing when to pay out bonuses to yourself, you can effectively move your personal income from one calendar to the next. For example, you can deduct a bonus payable of $50,000 in your corporate year ended December 2018. If you don’t actually pay that bonus until January 2019, you only pay personal tax when you file your 2019 tax return. This can help you avoid income spikes that would push you into higher tax brackets.
When you shouldn’t incorporate
You spend everything you make
- Although the lower tax rates are enticing, they only apply to earnings kept inside the corporation. If you subsequently withdraw these earnings as dividends to fund your lifestyle….the combination of the corporate tax on the profit and the personal tax on the dividends will be just as high as it would be for a sole proprietor earning the same income.
You have losses (and other income to write it off against)
- Losses incurred by a corporation are not deductible to shareholders. They can be carried forward and applied against future profits, but they cannot be used personally.
- Business losses of a sole proprietor are declared on their personal tax return. If they income from other sources, these losses can be written off against that income. For example, if you have a full time job and start a business on the side, you can deduct the losses from your startup against your employment income. This tax savings can be a good way to fund a fledgling business.
What does it cost to incorporate?
– $1,000 legal fees to set up (more if ownership structure is complicated)
– $250 – $300 per year to keep minute-book up to date (dividend resolutions, annual meetings, etc)
– $1,000++ accounting fees for annual financial statements and tax return
The complete rules for “Qualifying Small Business Shares” are beyond the scope of this document. They can be summarized as follows:
– The company is Canadian controlled and private(not public)
– Less than 50% of the assets have been passive for 24 months prior to the sale
– Less than 10% of the assets are passive at the time of the sale
For Questions contact firstname.lastname@example.org
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