Should you incorporate your small business? (Sole proprietorship, partnership etc)
Jumping from Sole Proprietorship to Corporation in Canada? We’ll break it down step by step.
Earning side income or owning a small business can be a very rewarding experience, both emotionally and financially. The obvious perks of such a venture are unlimited earning potential and a whole lot more freedom and choice.
In Canada a business can operate as a sole proprietorship or a corporation. Often most small businesses operate initially as sole proprietorships and later incorporate for various reasons discussed below.
Editor’s Note: The same principles discussed in relation to sole proprietorships apply to limited partnerships.
Sole proprietorships typically have the following government reporting requirements:
Very Limited Liability Protection:
Under a sole proprietorship the owner is personally responsible for all debts and liabilities and legal costs of the business. These debts may include credit cards, business loans or liabilities arising out of lawsuits. If the small business operating as a sole proprietorship is unable to fulfill these debts a creditor is almost certain to seek restitution through the forced sale of personal assets (house, car, investments) of the owner in court.
Corporations may be subject, but not limited to the following reporting requirements:
Typically expenses written off by corporations can similarly be written off by sole proprietorships, however, a corporation allows for additional income splitting in certain situations which may lower overall taxation. For example, suppose a spouse is the shareholder of a corporation that manages the overall operations of the business. If the other spouse helps out the business with administration and other tasks a reasonable salary can be paid which can be written off by the business and taxed at a low personal rate.
Increased Liability Protection:
A corporation allows for an owner/shareholder to separate him or herself from the legal responsibilities of the business. If the corporation is unable to pay debts or liabilities the creditor or plaintiff may only seek assets owned by the corporation and not the shareholder. There are certain situations in which a shareholder may be personally liability, such as providing personal guarantees for corporate debts, remitting sales tax and payroll remittances, so talking with a knowledgeable lawyer is always a good idea.
Justification and advice on cost comparison vs value:
Often I see small business owners of both sole proprietorships and corporations attempting to skimp out on paying professional fees. Having run my own small accounting business myself, and having provided tax planning services in an accounting firm, I understand the value of these services is often difficult to quantify or justify, especially considering the cost of professional fees. However, I’ve also seen situations where personal and corporate bank accounts have been frozen by the CRA for non-compliance, or an unexpected tax bill cripples cash flow because these issues were neglected. There can be tax minimizing opportunities lost (such as tax deferral, income splitting and other deductions) by business owners when they fail to engage a competent accountant. Paying a competent professional can ensure a business handles these issues before they become massive problems.
The corporate small business tax rate in Ontario is 15% on the first $500,000 of income. Sweet sassy molassy, that’s way lower than the personal tax rates above. Why doesn’t everyone just incorporate? I know, right? Well, hold on there that rate is for income earned in the corporation and it must stay there until paid out to the owner via salary or dividends. This is where tax planning comes into play and can drastically affect your take home pay if you’re earning some decent money.
Here’s an example of a business earning $100,000 in income under the sole proprietorship VS corporation.
Now recall that for a corporation we have to pay a salary out to the owner in order for him or her to access the profits. If the owner wanted $70,000 in salary and wanted to leave $30,000 in the business for future investment it would look like this:
|Net Income||$100,000||$30,000 (reduced by $70k salary)|
|Business Taxes Payable||$26,600||$4,650|
|Employment Taxes Payable||$15,000|
|Total Taxes Payable||$26,600||$19,650|
By incorporating and paying a $70k salary the business owner would save close to $7k in taxes. If the business owner would live off a salary less than the net income of the corporation we can see considerable tax deferral and capital appreciation by leaving the funds in the corporation and investing. The Canadian corporate tax rate has decreased substantially over the last few decades to encourage business spending.
Final Decision: Incorporation: Is it right for you?
There are a lot of other considerations when thinking about incorporating a business. While the administrative and compliance responsibilities and costs are much greater under a corporate structure the benefits include liability mitigation of the owner, tax savings and estate planning. It probably doesn’t make sense for a small business with minimal operating risk and net income under $30k to incorporate as a low tax rate is already enjoyed. As a business grows so too do the tax liabilities and operational risk, which may indicate it’s time to prep those articles of incorporation. When a business reaches net income above $30k it may be a good time to discuss if it’s time for incorporation. Each business owner should consult with a lawyer and accountant to determine if the increased costs are offset by the benefits.