It’s often the case that a small business should consider the advantages and disadvantages of incorporating. In this post we look at what incorporation involves, and whether it makes sense for your business.
What is a corporation?
A corporation is a separate legal entity, formed by application to either the federal government, or one of the provincial/territorial governments. Funding of the corporation can be done through borrowing or the issue of shares to the owners of the business, the corporation’s shareholders.
How does taxation work?
Since a corporation is a separate legal entity, it pays a corporate income tax, calculated separately from the personal income tax of the owner/owners. If the corporation pays wages to the shareholders, then income tax, Canada Pension Plan contributions, and sometimes Employment Insurance premiums are deducted and remitted to Canada Revenue Agency.
Advantages of Incorporation
Unlike a sole proprietorship, where the business owner assumes all the liability of the company, 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. The liability is redistributed and the corporation is responsible for its own debts, with the exception of a personal guarantee or negligence.
Income tax advantage
With an incorporated company, there are a number of possible tax advantages.
For example, a corporation could pay less income tax than an unincorporated business due to the small business deduction. A Canadian controlled private corporation, or CCPC, pays a much lower rate of federal tax (small business rate) on the first $500,000 (in 2017) of active business income than would be paid by an unincorporated business. Active business income generally does not include investment income or rental income, which is taxed at regular corporate tax rates.
Other tax advantages include the capital gains deduction for the selling of shares, and the ability to pay out dividends. A qualifying small business corporation benefits from a $800,000+ capital gains deduction on the sale of shares.
Private Health Service Plans can be used to provide tax-free benefits to employees. This deduction is also available to sole proprietors and partners, but the treatment for corporations is more favorable than that for unincorporated businesses.
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 redistribute income from family members in higher tax brackets to family members with lower incomes that are taxed at a lower rate.
As a general rule, the higher the income of your small business, the more tax benefits you will gain from incorporating in Ontario.
Unlike a sole proprietorship, a corporation will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes.
Selling a corporation is more straightforward than attempting to sell a sole proprietorship.
Ability to raise money
It’s easier for corporations to raise money to support business growth and development. While corporations can borrow and incur debt like any sole proprietorship, they can also raise money by equity financing. This involves selling shares in the corporation to angel investors or venture capitalists, usually in exchange for convertible debt or ownership equity. Equity capital generally does not have to be repaid and incurs no interest.
May increase your business
Your target customer base may perceive corporations as being more stable than unincorporated businesses. Having Inc., Ltd., or Corp. as part of your company’s name can boost consumer confidence. Some companies will only do business with contractors who are incorporated, because of liability issues or the wish to have more of an “arms length” relationship.
Disadvantages of incorporation
As a business structure, incorporation has the highest setup and administrative costs. Being a more complex legal structure than a sole proprietorship or partnership, a corporation is more complicated and costly to create.
When setting up classes of shares, decide who will be shareholders (spouses, children) and how much control they will have (determined by % of voting shares owned).
Business losses cannot be written off against other income of the shareholders.
Running a corporation requires more paperwork than maintaining a sole proprietorship or partnership.
Corporate documents that must be kept up to date include minutes from corporate meetings, the register of directors, the share register, and the transfer register.
Annual reports must be filed with the corporate registry. Corporate tax returns are filed separately from the owners’ personal tax returns.
Get professional advice
So should you incorporate or not incorporate? To avoid problems, talk to us before you decide. We can go into more detail with you about incorporation as it relates to your particular business. We can point out the pros and the cons – how it might benefit your business vs. whether or not the trouble and expense are worth it to you.
We can also help you set up your business structure and organize your accounting records properly at the start of your business. You want to have an exact picture before you make any decisions.