Should I incorporate my business?

Thinking about incorporating your business?  Here are some things to think about first.

• Should I incorporate my small business?
• When should I incorporate?
• I want to save on legal fees, can I handle the incorporation myself?
• Is it true that I can save a bunch of tax by incorporating?
• What are the pros and cons of incorporating your business?

 

We get asked these questions every week and there is no simple answer.  Each situation is unique and should be looked at individually.  We have prepared this guide to help you decide if incorporating is a good choice for your business by explaining the pros and cons of incorporating your business in Canada.

 

Advantages of Incorporating Your Business

Below is a summary of the advantages of incorporating your small business and some detail on each item.

 

• Limited Liability — Operating your business through a corporation provides a layer of security against personal liability. It makes it more difficult for someone to go after your personal assets if the business defaults on its debts.  This threat can also be eliminated with sufficient insurance.  
• Tax Savings and Deferral — In some situations, corporations have a lower tax rate than individuals. Operating your business through a corporation instead of a sole proprietorship or partnership can help to defer and save taxes.  If your business earns $120,000 after expenses and you need all of that money to live on, then the savings and deferral is eliminated as you would be removing all of the money from the corporation.  This is ONLY beneficial if your company earns excess funds than you require.
•  Income Splitting — Due to revised tax rules in 2018, this isn’t as advantageous as it once was.  Income splitting used to be a major reason for incorporating your small business.
•  Lifetime Capital Gains Exemption (LCGE) — The LCGE allows some incorporated businesses to sell at a gain of up to $866,912 without paying any tax.  While it does happen, many business sales are asset sales, not share sales as buying the shares of a corporation from the seller opens the buyer up to issues that may be unknown at the time of purchase.
•  Estate Planning — A corporation is a separate entity to you, so it continues to live on regardless of what happens to you. This can be helpful when planning to transfer your assets to others.  

INCORPORATION LIMITED LIABILITY

When operating a business, there is a risk the business will incur losses or will build up debts it cannot pay.

If the business operates as a proprietorship or partnership, your personal assets such as your house and car can be seized to pay for the business’ debts.

If you are operating your business through a corporation, liability is limited to assets held within the company. Your personal assets would not normally be at risk should the business fail to pay its debts.

For example, if a gas-fitter incorrectly installs a hot water tank that has a gas leak that explodes, his customer could sue for damages.

If the gas-fitter is operating his business as a sole proprietor, the home-owner could go after the personal assets to pay for damages. However, if the business operates as a corporation, only the assets within the corporation would be at risk.

TAX SAVINGS AND DEFERRAL

Corporate tax rates for small businesses in Canada can be quite low when compared to personal tax rates. This provides the opportunity to save tax or defer tax when operating a business through a corporation.

There are many factors to consider when contemplating the tax effects of incorporating. Operating your business through a corporation provides more flexibility in how (salary vs. dividends) and when personal income of the shareholder is earned. This can result in less tax paid.

For example, Jodie operates a sporting goods store that earns $350,000 per year after expenses. Jodie only needs $100,000 annually to support her family.  In this case, $250,000 can be left in the corporation and Jodie doesn’t have to pay tax on the $250,000 that is left in the corporation.  Note, the tax isn’t avoided, just deferred.  At some point, the funds will be removed from the corporation (either through payroll or dividends) and there will be tax to be paid at that time.

INCOME SPLITTING

Before 2018, income splitting was one of the more common reasons people incorporated their businesses. Dividends could be used to distribute business income to a lower-income spouse, who would then be taxed at a lower rate.

As of January 1, 2018, regulatory changes (called a tax on split income or TOSI) have significantly limited the ability to use this technique. The rules are designed to limit the benefit of income splitting through private corporations.

TOSI rules apply when the income recipient is an adult family member and has not made a sufficient contribution to the business. The guideline for “sufficient contribution” is working an average of 20 hours per week in the business.

If an adult family member doesn’t work an average of 20 hours per week in the business, and is paid a dividend, this income would be taxed at a higher rate than those members that are actively involved in the business an average of 20 hours per week.  This increased rate makes income splitting through dividends not beneficial.

LIFETIME CAPITAL GAINS EXEMPTION (LCGE)

The Lifetime Capital Gains Exemption provides owners of Canadian Controlled Private Corporations (most small incorporated businesses in Canada) with tax-free capital gains of up to $866,912.

Let’s look at a scenario to explain how amazing this exemption really is.

For example, Justin operates a delivery business that he started 25 years ago using his parents vehicle.  Through hard work, this business now has 30 employees and annual revenues in excess of $2,000,000.  Justin is now older and wants to spend time with his grandchildren.  None of his children are interested in taking over the business, so Justin has decided to sell the business to one of his longest tenured employees who has offered $775,000 for the shares of the business.   Since Justin had built the business up from nothing, the cost to him is zero.  This gives him a capital gain of $775,000.

As Justin had incorporated the business in the beginning, and all the requirements are met*, the sale will qualify for the LCGE and the full $775,000 gain would be exempt from tax. He would pay $0 in tax!  If the business wasn’t incorporated, this gain would cost Justin over $175,000 in tax.

There are a few specific requirements that must be met before the LCGE can be claimed on the sale of an incorporated business. More details are found here.

ESTATE PLANNING

A corporation is a separate entity to the business owner. The corporation has the same rights and obligations under Canadian law as a natural person. This means it can acquire assets, obtain a loan, and enter into contracts.

This means the corporation will continues to exist even when the business owner passes away. If that were to happen, ownership of the business shares would transfer to the shareholder’s heirs. This is not the case for a partnership or sole proprietorship, which cease to exist on the death of their owners.

This allows you to plan over a longer-term. It provides flexibility when transferring assets to others. If you’re planning on building a lasting business to pass onto the next generation, then a corporate structure maybe your best option.

Disadvantages of Incorporating Your Business

When deciding if to incorporate, you need to weigh the advantages against a list of disadvantages, which we’ll discuss next.

We’ll begin with a brief overview of the disadvantages and then go into more detail for each.

 

• Incorporation Costs — There are costs involved when starting a company. Having a lawyer help draft the documents of incorporation is a good idea, but it isn’t cheap.
• Ongoing Costs — There are annual legal filing fees to be paid as well as fees to have an accountant file the annual corporate tax return.
• Administrative Burden — The corporation requires legal and tax filings each year to remain in good standing with the federal and provincial authorities. This requires attention and is a time commitment for the owner(s).  These tax filings are in addition to, not in lieu of the shareholders’ personal tax returns.
• Losses More Difficult to Use — If your business sustains financial losses, it is more difficult in a corporation than in a proprietorship to use those losses to reduce future taxes because the losses can only be used inside the corporation against future earnings of the corporation whereas losses from a sole proprietorship can be used against other earnings of the individual.
• Pay More Taxes — In some scenarios operating your business through a corporation could actually mean you pay more taxes than if operating as a proprietorship.   As an example, see example of real estate rental business below.

INITIAL INCORPORATION COSTS

Incorporating comes with a few costs attached.

 

• DIY Incorporation — You can look after the incorporation of your business yourself. Depending on where you incorporate (Federally or Provincially), the cost to DIY ranges from $200 - $500.  We NEVER recommend you do this.  This is not the place to save a dollar.  We know starting a business is stressful and costly, and every dollar counts, but, If you are starting off and think $2,000 is expensive for this foundational work, don’t proceed because the annual compliance costs will definitely scare you away.  We strongly recommend the use of a lawyer here.
• Incorporation by Lawyer — If you hire a lawyer to do the incorporation for you (and you should), the costs can range significantly. A common range is between $1,000 and $2,000, but expect to pay more depending on the level of complexity (numerous classes of shares, number of shareholders etc.).
• Shareholder Agreement — If you have business partners, it’s a good idea to have a lawyer help create the shareholder agreement. This will give you something to fall back on if shareholder relations go south. The cost of this will again depend on the lawyer, but you can expect to pay between $500 and $1,000.  Again, don’t forego this to save a dollar.  It is much more costly to pay lawyers to deal with disagreements between shareholders when one feels wronged than to prepare a document spelling out what happens in the case of a disagreement.

ONGOING COMPLIANCE COSTS ASSOCIATED WITH CORPORATIONS

You’ll also have additional ongoing costs with incorporation. These can include:

 

• DIY Annual Legal Filings — Depending on the jurisdiction of the corporation, the corporation requires legal filings to be completed yearly to stay in good standing.  Some provinces have this filing as part of the tax return, others such as federal corporations require a separate annual filing that costs approximately $50-$100.
• Legal Filings by Lawyer — You will need to update your minute book every year.  Lawyer’s prices vary, but somewhere in the $400-$500 per year is a fairly standard price.
• Corporate Tax Filings — Depending on your province, you will have to file 1 or 2 corporate tax returns.  This can be done in-house, or by an accountant.  Depending on complexity, the cost would start at $1,200 and increase based on time required to prepare return(s).

ADMINISTRATIVE BURDEN OF INCORPORATING YOUR BUSINESS

As you can see, you may end up dealing with professionals more often when you operate your business through a corporation than if you operate as a sole proprietor.

The corporation is a separate entity, which means you have to keep the corporate filings up-to-date in addition to your own. You’ll also need to make sure it remains in good standing with the federal and provincial authorities.

If the time ever comes where you need to wind down the corporation, it is not as simple as ceasing operation, there is a whole other list of things you, your lawyer, and accountant will have to do to end things properly.

If you’re not a fan of paperwork and deadlines, you would be safe to hire professionals to handle these tasks so that you can concentrate on what you do best, operating your business.

LOSSES ARE LIMITED TO CORPORATE USE

It’s common for start-up businesses to incur losses in the beginning. When you operate a proprietorship and incur a loss, you can deduct that loss against your other sources of personal income.

If you were operating that same business through a corporation, the loss could not be applied to your personal income. Instead, the loss can only be applied to another year’s corporate tax return to reduce tax within the company only.

The corporation can carry the loss backward up to three years to receive a refund of some previously-paid taxes. Or the corporation can carry the loss forward up to twenty years to reduce taxable income in the future.

PAY MORE TAXES

In some specific situations, income earned in a corporation may be taxed at a higher rate than income earned outside of a corporation such as from a partnership or sole proprietorship. This most often occurs when the small business deduction is not available to corporations.

Contact your accountant to discuss your scenario to see if this will be the case or not.

Should You Incorporate Your Business?

The decision of whether to incorporate or not is not easy.  No one has a crystal ball to see what will happen.  You have to base your decision on your best guess as to what will happen and what you want to accomplish.   

There are times when incorporation is the best option and other times when it’s better to operate as a proprietorship. Here are some examples and recommendations for each scenario.

These examples are VERY simplified to help explain the general concepts. Before making a decision, discussion with your accountant and lawyer are recommended.  

 

CONCERNED ABOUT LIABILITY

Liability is one of the more common reasons why people choose to incorporate their small business in Canada. In the event debtors come after the business, incorporating limits liability. This means only the assets held within the company could be in danger.  As mentioned previously, some of the risk can be mitigated with proper insurance.  

While Incorporation can often save the business owner from personal financial ruin, it is important to note there are circumstances where directors of incorporated businesses can remain personally liable for the debts of the business.

The most common of these are:

 

• Unpaid employee wages and vacation pay
• Government trust accounts such as Payroll remittances and GST/HST
• Any debts that have been personally guaranteed by the shareholder.  This is common for many new corporations with little history

Summary: Liability concerns can mean that incorporation is the right choice.

BUILDING A BUSINESS TO ONE DAY SELL

If you have intentions of one day selling your business, incorporation can save you a lot of tax.

Operating your business through a Canadian Controlled Private Corporation (CCPC) can allow you to sell your shares at a gain of over $800,000 without paying any tax. This is accomplished via the lifetime capital gains exemption (LCGE).

Some specific criteria have to be met for the LCGE to apply. Here is a simplified version of these criteria:

 

• Asset test —  90% or more of the company’s assets must be used in active business (aka not holding passive investments) at the time of the sale.
• Basic asset test — 50% of the company’s assets must be used in active business (aka not holding passive investments) for the entire 24 month period before the sale.
• Holding period test — The owner of the business must have owned the shares for at least 24 months before the date of the sale.

While it is often simple to meet these criteria, speak to your accountant well in advance of the sale to ensure things are set up in a way to meet the criteria listed above.  Failure to do so can cost you thousands of dollars.

Summary: When growing a business to sell, incorporation can reduce taxes at time of sale.

BUSINESS EARNS MORE CASH THAN YOU NEED

We previously discussed tax savings and deferral. The scenario in which you can benefit from tax deferral is when the business earns more cash than you need in a given year.  We’re not talking $20-30,000 here.  $30,000 is a significant amount of money, but If your business earns $100,000 and you need $70,000, don’t incorporate if tax savings is the ONLY reason.  The tax savings of $30,000 will probably not even cover your annual compliance costs.  There are other less expensive ways to save taxes if you are only dealing with $30,000. We’re talking about a significant amount of money.  If your business earns $200,000 and you need $100,000, there is a much more significant savings here and incorporation may be of use for tax savings.

Summary: If the business earns more cash than the owner needs for living costs and saving for retirement, then incorporating can defer and potentially save taxes.

YOU ARE THE BUSINESS

There are many businesses out there where the owner really is the entire business. In these situations, there may not be much motivation to incorporate.

For example, Nina has a truck that she drives around the city as a mobile sharpening company.  She sharpens knives, lawnmower blades, skates and anything else with a blade.  Nina only has one truck.  There are no other employees and very few assets.  She has found it difficult to find someone to take over the business as it generates very little income.  There isn’t much risk in the business other than possibly a vehicular accident and Nina has sufficient insurance for this risk.  When she decides to retire, the business will most likely cease to exist as she IS the business.

In this type of situation, there is very little upside to incorporating.

 

• All income earned is used by owner so there is no excess income;
• Risk is mitigated with insurance, and
• The business is likely not going to be sold.

Summary: Owner-operated businesses, where the owner really is the entire business, have limited benefits from incorporating.

REAL ESTATE RENTAL BUSINESSES

Owning real estate for rental is a great way to build wealth and as a popular way to invest, people often ask if there are tax advantages of earning rental income within a corporation.

Unless the business employs more than five full time employees, there is no tax advantage to operating a real estate rental business through a corporation.  Below six employees the rental income earned through the corporation is classified as investment income and taxed at a higher rate (because the small business deduction would not be applicable) than would be paid if the corporation employs over five employees.

 

Summary: The tax savings of a corporation are not available until the corporation has more than five full time employees.