Many small business owners consider whether to incorporate their businesses at some point. There are a number of advantages to incorporation in Canada, but there are also some disadvantages, as we will explore in this article.
Note that the form of business ownership isn't fixed forever. You can change the legal structure of your business as it grows. It's common for small businesses to start out as sole proprietorships or partnerships and become incorporated at some later date.
Is incorporation a wise move for your small business? Let's look at the pros and cons.
Advantages of Incorporating
The main advantage to incorporating is the limited liability of the incorporated company. Unlike the 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 they have 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.
Corporations also have the same rights as individuals; meaning they can own property, carry on business, incur liabilities, and sue or be sued.
Corporations Carry On
Another advantage of incorporating is continuance. Unlike a sole proprietorship, a corporation has an unlimited lifespan—it will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes. This makes selling a corporation more straightforward than attempting to sell a sole proprietorship.
Raising Money Is Easier
Corporations also have easier access to financing, which may make it easier for your business to grow and develop. Lenders will often give corporations lower rates for loans. Additionally, corporations may find it easier to get equity financing from angel investors or venture capitalists.
Optimizing Your Income and Taxes
If you incorporate your small business, you can determine when and how you receive income from the business, which is a real tax advantage. Instead of taking a salary from the business when the business receives income, being incorporated allows you to take your income at a time when you'll pay less in tax. You can also receive income from an incorporated business in the form of dividends rather than salary, which will lower your tax bill.
Potential Tax Deferral
Becoming incorporated gives you tax deferral potential if you are a higher income earner. Business tax rates are much lower than personal tax rates, so if your individual marginal tax rate is high and you don't need the funds for personal use, you can elect to leave money in the business and take it out at a later date when your personal tax rate is lower.
For example, say your Canadian business had $300,000 in earnings after expenses for the year:
- If you took out the entire $300,000 as salary in 2019 (and had no deductions), you would pay $78,296 in personal taxes, a marginal tax rate of 29.6%.
- If you took out $200,000 as salary in 2019, you would pay $45,711 in personal taxes, a marginal tax rate of 22.9%.
- On the $100,000 left in the company, the general corporate tax would be 15% for a total of $15,000. So, your total tax in this scenario would be $45,711 in personal tax plus $15,000 in corporate tax, or $60,711—a savings of $17,585 in taxes compared to taking out the entire $300,000 as salary.
The Small Business Tax Deduction
If you incorporate your business, it may qualify for the federal small business deduction (SBD). The SBD is calculated at the rate of 9% on the first $500,000 of taxable income, which may reduce your net corporate business tax to a much lower tax rate than you would receive on your personal income.
Having Ltd., Inc., Ltee., or Corp. as part of your company's name may increase your business, as people perceive corporations as more stable 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 or the wish to have more of an "arms-length" relationship.
Business Name Protection
When you incorporate your business in a state or province, the business name you choose is reserved for your use in that state or province, or if you incorporate your business federally, you have the right to use your business name throughout the country. Sole proprietorships and partnerships have absolutely no business name protection. If your business is not incorporated, anyone can start a business with the same or a similar name.
Incorporating your small business sounds like a great idea, doesn't it? But there are also disadvantages that you need to consider.
Disadvantages of Incorporating
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. This, of course, will mean increased accounting fees.
There is a lot more paperwork involved in maintaining a corporation than a sole proprietorship or partnership. Corporations, for example, must 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.
No Personal Tax Credits
It's possible that being incorporated may actually be a tax disadvantage for your business. Corporations are not eligible for personal tax credits. Every dollar a corporation earned is taxed. As a sole proprietor, you may be able to claim tax credits a corporation could not.
Less Tax Flexibility
A corporation doesn't have the same flexibility in handling business losses that a sole proprietorship or a partnership does. As a sole proprietor, if your business experiences operating losses, you could use the loss 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.
Liability May Not Be as Limited as You Think
The prime advantage of incorporating—limited liability—may be undercut by personal guarantees or credit agreements. A corporation's much-vaunted limited liability is irrelevant if no one will give the corporation credit.
When a corporation has what lending institutions consider to be insufficient assets to secure debt financing, they often insist on personal guarantees from the business owner(s). So, although technically the corporation has limited liability, the owner still ends up being personally liable if the corporation can't meet its repayment obligations.
Registering a Corporation Is Expensive
Corporations are more expensive to set up than other business structures. A corporation is a more complex legal structure than a sole proprietorship or partnership, so it naturally carries more costs to set up. Fees for incorporating a small business federally or within a province range in the hundreds of dollars.
Closing a Corporation Is More Difficult
Closing a corporation requires passing a corporate resolution to dissolve the corporation, winding up payroll accounts, and sending a copy of the certificate of dissolution to your provincial authorities (or the Canada Revenue Agency). You will also need to file your final tax returns for the corporation.
Should You Incorporate?
You should definitely discuss your personal situation with your accountant and lawyer before you decide. They will be able to give you a more precise picture of how incorporation could benefit your business, and help you see whether the trouble and expense of incorporation will be worth it to you.