If you are wondering if it’s time to incorporate your business, you aren’t alone. It is one of the most common questions we get. Most business owners know that incorporating can provide them with protection from creditors and that there is some sort of tax benefit. Beyond that, it gets murky. Like most questions, the answer as to whether or not you should incorporate, is “it depends”. Let’s look at some factors that might influence your decision.
1. Will incorporating protect my personal assets?
Keeping your personal assets safe from business creditors is a good reason to incorporate. If you incorporate for this reason alone, it will be important to pay attention to the assets held by the corporation.
Suppose your unincorporated business purchased a car you use both personally and for business. When incorporating, it might not be a good idea to transfer the vehicle to the corporation. Why? Because if it is owned by the corporation, it won’t be protected from its creditors. We may recommend that you hold the vehicle personally and submit mileage claims to the corporation every month.
Similarly, if you keep cash or investments in your corporation to defer personal taxes, these will not be protected from corporate creditors. Your accountant can help devise a strategy to balance this risk with tax minimization.
2. Will incorporating result in tax savings?
Your business earnings and your family’s overall earnings should be considered in the decision to incorporate. One major benefit of incorporation is the potential to influence your family’s overall tax bill in a given year. Your ability to capitalize on this benefit will depend on how much of your business earnings you need for personal use and what your overall income is from all sources.
The details are beyond the scope of this article, but very generally, small Canadian corporations pay a favorable tax rate on active business income. If an owner does not need all of the corporate earnings for personal use, they can remain undistributed in the corporation thus deferring personal taxes until the earnings are withdrawn. This can lower the owner’s personal income and their personal tax rate for a given year.
Another way to benefit is to have your spouse buy shares of your corporation with their own funds. The corporation can issue dividends to each of you, providing an income splitting opportunity. This could lower your family’s overall tax rate.
However, if you or your spouse have income from other sources that puts you at the top bracket before any earnings from the corporation, every additional dollar of earnings will be at the top rate. While you may still be able to defer tax to another year, there is no opportunity to reduce your tax rate.
3. What if I own other incorporated businesses?
The favorable tax rate available to small corporations is subject to limits, including an earning limit. This limit must be shared amongst associated corporations. If you own more than one incorporated business, it is important to look at their combined earnings when making the decision to incorporate. If earnings of these businesses are already at or near the limit, this may negate the tax benefit of incorporating another business.
Also, favorable tax rates only apply to active business income. To the extent that the company’s earnings come from rental properties or investment income, you will not be able to take advantage of the small corporation tax rates.
4. My business has more than one owner. Does that make a difference?
If your business has more than one owner, incorporating can provide more protection than structuring the business as a partnership. Generally, the liability of each corporate shareholder is limited to their investment in the corporation (unless they have personally guaranteed corporate debt). This may not be the case in a partnership, where each partner may be liable for all of the obligations of the company if the other partners are unable to meet their share of the obligation.
5. Is incorporating worth the Investment?
Finally, when deciding to incorporate, you should consider if the benefits justify the costs. Incorporating requires an investment of your time and your money.
Incorporating is a business transition that, at the start, might take up more time than you expect. Visits to advisors, gathering information, making new banking arrangements and other transitional tasks will all be on your to do list.
You will want to involve your lawyer. While you can incorporate on your own, that’s only the start. Your lawyer will ensure that your new corporation is properly documented and has a share structure that will work as your business evolves. This can save you money in the long run.
Your accountant is a valuable ally at this critical time. Tax planning starts at day one. The selection of the corporation’s year end date and the way personally owned business assets are transferred to the corporation can have implications for your tax bill. On top of this, new CRA accounts will need to be set up for the new corporation and the proprietorship CRA accounts may need to be finalized and closed (payroll, GST/HST etc.).
Also part of the transition is closing off your proprietorship books and opening a new set for your corporation. This is a great opportunity to make changes to improve performance and financial reporting.
After the transition is complete, the corporation will require an annual compilation financial statement (at a minimum) and its own tax return. Further, your lawyer will have annual filings and compliance activities to complete for the corporation. This translates into ongoing new costs for the business and these should be weighed against the benefits when deciding to incorporate.