Pros and Cons of Incorporating your small business

The decision to incorporate can be a difficult one that many small businesses face at some point in their lifetime and . Incorporation, literally, represents the creation of a new person.  Whereas a sole proprietorship is an extension of one's self, a corporation takes on a life of it's own; it can give birth to subsidiary, marry via a merger and die with a dissolution.  It has to file it's own tax return, can be sued and has a set of rules that govern it's existence.  Below are some of the points to consider when deciding whether to incorporate:

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Benefits

• Limited liability:

  A corporation, as mentioned above, creates a new person that is distinct from the creator. As such the liability of the company is limited to the shareholders' investment. (This does not apply in the case of personal guarantees or where directors have specific obligations etc.) This means that in most cases, if a corporation is sued, its potential losses are limited to their investment in the corporation. Note that there are some cases where director’s liability applies or where the corporate owner(s) is personally liable for the debts of a corporation.

• Lower Tax Rates:

  Corporations, particularly small businesses, benefit from corporate tax rates that are lower than individual tax rates. The combined federal and corporate tax rate in Quebec is 26.6% while the small business corporate rate in Quebec ranges between 15% and 20.6%, depending of the number of hours worked by employees in the corporation. Note that lower tax rates do not usually apply to incorporated rental properties and other types of investment related businesses that generate passive income, unless you have 6 or more employees.

• LIfetime Capital Gains Exemption:

  Owners of small business shares benefit from a lifetime capital gains exemption of $866,912. This allows a shareholder to sell the shares of qualifying corporations tax free for gains up to $866k Note that this represents the full amount of the gain. The actual taxable capital gains is 50% of this amount is $433,456. The balance of 433k is non taxable in the hands of the shareholder.

• Tax Deferral:

  If the profit/cash flow of the corporation exceeds the amount required by the owner for salaries and expenses, the excess amounts can be left int the corporation. There are several strategies for corporate small business investments - many financial institutions tailor investment products specifically for corporations. It should be noted that passive income (investment, rental etc.) are taxed at a higher rate than business income approximating 50% in most provinces. This is accumulated in the corporation as a refundable dividend tax which is refunded to the shareholder upon payment of dividends.

• Access to Capital

  Corporations generally have more ways of raising capital eg. they can issue shares or sell bonds. Banks are often more comfortable lending to corporate entities with some established history. A corporation can be perceived as more professional than a sole proprietorship.

• Income Splitting:

  Shares of corporations can be allocated among family members allowing them to draw dividend income from the business. Keep in mind that the federal government targeted this type of tax planning and has imposed a set of criteria that evaluates the tax rate on dividends received by family members of business owners (note this does not apply to salaries). Although the rules are very complex, the new TOSI (tax on split income) legislation essentially attempts to determine whether the shareholder is actively involved in the corporation, specifically younger shareholders, to ensure that owners are not trying to reduce their tax bills by allocating dividends to related taxpayers with much lower tax payers. It is helpful to read this article which explains it in greater detail.

• Value/Continuous Existence:

  A corporation is easier to value given that it is an self contained entity. Additionally it can continue to exist after the death of founders/shareholders through sale or transfer of shares.

Detriments

• Higher Costs:

  There are costs relating to setting up a corporation and ongoing maintenance including governmental, legal and accounting fees which are usually higher than for a sole proprietorship.

• Greater Administration:

  A separate set of legal and accounting records needs to be maintained. The accounting function is more involved since the reporting required for the corporate tax return is more extensive and often requires actual accounting software rather than just an excel sheet which is what many unincorporated business owners use. Additionally, a corporation needs to file an annual return and a corporate tax return each year that is separate from each shareholder's personal tax return. Any changes to the corporation structure, address etc must be registered.

• Complex Structure and Taxation:

  Corporations by their nature are more complex. Additionally there are numerous tax considerations that can arise from corporate transactions including use of assets for personal reasons, transfer of assets to related parties, tax on capital, dividends to related family members (see above) etc.

• Double Taxation:

  Both the profits and the distributions to shareholders are taxed sometimes resulting in double taxation especially for individuals in higher tax brackets. Note that Revenue Canada has a stated goal of integration whereby taxes paid personally on salaries should be more or less the same than income earned from a corporation through dividends, once corporate taxes are taken into account. This is a complex topic and while integration is not always perfect, it is usually close.

• Losses:

  Corporate losses remain within the corporation and cannot be transferred to the shareholder whereas with a sole proprietorship losses, with certain exceptions, can be offset against other sources of income thereby reducing taxes payable. A corporation may however amalgamate with another corporation to utilize its losses.

Sometimes it is beneficial to incorporate at the inception of a business while at other times it makes more sense to wait. Anticipated size of the corporation, whether there will be excess funds, do you intend to apply for financing can all be contributing factors to the decision. Please refer to our book for more detailed information about incorporating .  As always with these matters, it is beneficial to obtain the advice and assistance of a lawyer and/or accountant.      

Ronika Khanna is an accounting and finance professional who helps small businesses achieve their financial goals. She is the author of several books for small businesses and also provides financial consulting services.

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