Should I incorporate my small business? When should I incorporate? I was told I can save a bunch of tax if I incorporate, is that true?
The question comes in many forms and the issue is a complex one. This article will help you understand the pros and cons of incorporating your business in Canada. It will also give you examples of when it may be a good idea to incorporate and when you might want to avoid it.
Advantages of Incorporating Your Business
Let’s start with a brief summary of the advantages to incorporating and then we’ll go into more detail for 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.
Tax Savings and Deferral - In some situations, corporations have a lower tax rate than individuals. Operating your business through a corporation instead of a proprietorship can help to defer and save taxes.
Income Splitting (2019 Update) - Income splitting used to be a major reason for incorporating your small business. This has changed significantly due to some new tax regulations and is now much less of an advantage.
Lifetime Capital Gains Exemption (LCGE) - The LCGE allows some incorporated businesses to be sold at a gain of up to $866,912 without paying any tax.
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.
When operating a business, there is a risk that the business will incur losses or will build up debts which it cannot pay.
If the business is operated as a proprietorship, 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 an electrician installs faulty wiring that causes a fire, his customer could sue for damages.
If the electrician is operating his business as a sole proprietor, the plaintiff could go after the personal assets of the electrician to pay for damages. However, if the business is operated through a corporation, just 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 when considering tax effects of incorporating. Operating your business through a corporation provides more flexibility in how and when income is earned. This can result in less tax paid.
For example, Heidi operates a tool rental business that earns $180,000 per year. However, Heidi only needs $80,000 annually to support her lifestyle.
If Heidi operated the business as a proprietorship, she would pay personal tax on the full $180,000 in the current year. She would owe approximately $60,000 in tax.
However if she operated her business through a corporation, she could choose to only take out $90,000 from her corporation in the current year. She would then only owe tax in the amount of around $40,000 in total during the year ($18,000 corporate tax, $22,000 personal).
The $20,000 in saved taxes could be left in the company and used to grow the business.
This concept can be a little bit misleading. Heidi hasn’t really avoided paying $20,000 in tax, she has just deferred that tax. When she eventually decides to withdraw that money from the corporation, she will have to pay personal tax on that income.
If she decided instead to use the money within the corporation to buy income producing assets (power tools to rent out or vehicle to deliver things for example), then she would not ever have to pay personal tax on those funds.
The real benefits come from the ability to use deferred tax dollars to grow your business. You also gain the ability to plan out personal income to take advantage of lower marginal tax rates.
Income Splitting (2019 Update)
Prior to 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 which would then be taxed at a lower rate.
As of January 1, 2018 regulatory changes (called 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.
The main thing to keep in mind is that dividends to adult family members who are not active in the business are taxed at a high rate. You can read our in-depth TOSI article for more details on this.
The benefit of income splitting as a benefit of incorporated has been significantly reduced.
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, Paul operates an accounting practice that he started from scratch and has grown to annual revenue of $850,000. Paul is considering retiring and would like to sell his accounting practice.
Paul finds a buyer who is willing to pay $865,000 for the shares of his practice. Because Paul built the practice from the ground-up, the cost of the accounting practice is $0. This means there is a gain of $865,000 on the sale.
If Paul operated the accounting practice as a sole proprietorship, the $865,000 would be a taxable gain. Paul would then pay approximately $180,000 in taxes.
If Paul operated the accounting practice through a corporation, he could qualify for the LCGE and the full $865,000 gain would be exempt from tax. He would pay $0 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 can be found here.
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 that it can acquire assets, obtain a loan, and enter into contracts.
This means that the corporation continues to exist even if the business owner passes away. If that were to happen, ownership of the business be transferred to the shareholder’s heirs. This is not the case for partnerships or sole proprietorships, which cease to exist on the death of their owners.
This stability allows you and the corporation to plan over a longer term. It provides more flexibility when transferring assets to others. If you’re planning on building a lasting business that can be passed on to the next generation, then a corporate structure may be your best option.
Disadvantages of Incorporating Your Business
When making the decision to incorporate, the advantages need to be weighed against a list of disadvantages which we’ll discuss next.
We’ll again list 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 stead with the authorities. This requires attention and is a time commitment for the owner(s).
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.
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.
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 DIY cost ranges from $100 - $400.
Incorporation By Lawyer - If you hire a lawyer to do the incorporation for you, the costs will range significantly. A common range we see is between $1,000 and $2,000 but we have definitely seen higher costs depending on location and level of complexity.
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.
You’ll also have additional ongoing costs with an incorporation. This can include:
DIY Annual Legal Filings - The corporation requires legal filings to be completed yearly to stay in good standing. You can do this yourself for around $20 to $50.
Legal Filings by Lawyer - You can pay a lawyer to look after your legal filings on behalf of the company. The cost is pretty standard across law offices between $300 and $400.
DIY Corporate Tax Filings - The company also has an income tax return that needs to be filed annually. You can do this yourself manually for free (more info), or using off-the-shelf software for about $250 per year.
Corporate Tax Filings By Accountant - You can also pay an accountant to file your corporate tax return. Price ranges depend on complexity but we often see corporate tax filings within the $1,500 to $2,000 range.
As you can see with the lists of additional costs, you may end up dealing with expensive professionals more often if you operate your business through a corporation.
The corporation is a separate entity which means that you have to keep its filings up-to-date on top of your own. You’ll also need to make sure that it remains in good standing with the authorities.
When shutting down the corporation there is a whole other checklist that you’ll have to run through to end things properly.
If you’re allergic to paperwork, you might want to consider avoiding the extra administrative burden of a corporation.
Losses Are More Difficult to Use
It’s not uncommon for start-up businesses to incur losses at first. When you operate a proprietorship and incur a loss, you can deduct that loss against your other 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 be applied to another year’s corporate tax return to reduce tax within the company only.
The company could carry the loss backward up to three years to receive a refund of some previously-paid taxes. Or the company can carry the loss forward up to twenty years to reduce taxable income on a future return.
The benefit is that losses can reduce corporate income in other years. This is less helpful than it would be to have the loss directly reduce personal income taxes in the current year.
Pay More Taxes
In some situations you may end up paying more tax when operating a business through a corporation. This most often occurs when the small business deduction is not available to corporations.
In addition, personal tax credits available to unincorporated business owners can mean that a proprietorship pays less tax than a corporation.
It is less common for a corporation to pay higher taxes overall, but the situation can exist. We recommend discussing your scenario with your accountant to see if this will be the case or not.
Should You Incorporate?
Even after reviewing the pros and cons it’s not easy to determine if you should incorporate your business. Sometimes, people may just assume that incorporation is the best way to go because it seems like the gold standard for running a business. This isn’t always the case.
There are certain times when incorporation is warranted and other times when it’s better to operate as a proprietorship. To try and provide some clarity, we’ll walk through some examples and discuss recommendations for each scenario.
These examples are simplified to help explain the general concepts. We recommend discussing with your accountant and lawyer before making a decision.
Concerned About Liability
Liability is one of the more common reasons why people choose to incorporate their small business in Canada. In the event that debtors come after the business, incorporating limits liability. This means that only the assets held within the company could be in danger.
Incorporation can often save the business owner from personal financial ruin. However, it is important to note that 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
Payroll remittances still owed to the Receiver General
GST/HST that has been collected by the corporation but was not remitted to the Receiver General
Banks and other debtors often require a personal guarantee for early stage corporate businesses. This means that the shareholder(s) would still be personally liable for the debts.
Summary: liability concerns can mean that incorporation is the right choice.
Building a Business to Sell
If you are starting your business with the intention of eventually selling it, then 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 $867k without paying any tax. This is accomplished via the lifetime capital gains exemption (LCGE).
There are some specific criteria that 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 held the shares for at least 24 months before the date of the sale.
Most of the time, it’s quite easy to meet these criteria and save a whole lot of tax on the sale of your small business.
Summary: when growing a business to sell, incorporation can reduce taxes.
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.
If your business is earning more than you need for living expenses, the extra cash can be left in the company. This means that only the lower rate corporate tax is paid and not the higher rate personal tax.
The additional tax is deferred until it’s paid out to shareholders in the form of wages or dividends. (Learn more about the difference between salaries and dividends)
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 Your 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, Bob The Bathtub Baron drives around in his van repairing and refinishing bathtubs. He has a spouse and two adult children who are not interested in going into the bathtub repair business.
We can assume that the business is not being built to sell, it is in a low risk industry and the business just earns enough for Bob to live on and save for retirement.
We’ve just eliminated some of the main reasons for incorporating so now we’re left with the downsides. Bob can avoid the additional costs and administrative burden by operating his business as a proprietorship.
Summary: owner operated businesses, where the owner really is the entire business, see limited benefits from incorporating.
Some businesses take a while to get off the ground. It’s not uncommon to see businesses operating at a loss for multiple years before taking off.
If the loss is incurred through a sole proprietorship, the business owner can apply that loss against his other income to reduce personal taxes. If the business was incorporated, the loss could only be applied against future corporate income.
Assuming that the losses could be used personally by the owner, the advantage goes to the proprietorship. The business could then be incorporated once it started to see profits (if there were other compelling reasons for incorporation).
Summary: if a business expects losses in the beginning, it can benefit the owner(s) to delay or avoid incorporation.
Real Estate Rental Businesses
Operating a real estate rental business can be a great way to earn income and create wealth. We often have people asking about the tax advantages of holding real estate within a corporation and earning rental income.
In many cases, there is no tax advantage to operating a real estate rental business through a corporation. Until the business becomes quite large (employs more than 5 full-time employees), the rental income earned through the corporation is classified as investment income.
Investment income is taxed at a higher rate than business income because the small business deduction does not apply. This has just removed one of the main benefits of operating a Canadian Controlled Private Corporation.
There are a couple of other reasons why it can be better to own real estate personally instead of through a corporation:
It is often easier to obtain a mortgage personally than through a corporation, and
If you live in the property before or after renting it, you may be able to use the principal residence exemption to reduce some capital gains tax upon sale of the property.
There are always other factors and scenarios where owning real estate through a corporation is beneficial. However, we often see personal ownership as the better option for property holdings when there are less than 6 full time employees working in the business.
Summary: rental income earned through a corporation is taxed at a higher rate until the business surpasses a size threshold. This removes much of the tax advantage of the corporate business structure.
Ask Avalon About Incorporation
There are a lot of factors to consider when deciding to incorporate your business. We always like having this discussion because we can help you to start your business on the right track.
If you’re unsure whether you should incorporate your business, Break the Ice. We’ll get back to you right away to see how we can help.