At Compass Accounting, some of the most common inquiries we receive are about incorporation. So, if you’re trying to decide whether or not it makes sense to incorporate your business, you’re certainly not alone.
For some businesses, incorporation is important from day one. For others, it may never be a necessity at all.
A wide range of factors can influence the decision to incorporate. These might include your business income, your personal income and assets, whether or not you have employees, whether or not you have business partners or investors, the level of risk associated with your business, your annual spending, and more.
Perhaps your small business started out as a side project and has evolved into something larger. Or maybe you want to build a well-defined corporate structure for your start-up right from the get-go.
No matter the reasons for it, incorporation is a big topic with plenty of facets to explore. Below, we’ll provide a brief overview of the main differences between sole proprietorship and incorporation. We’ll also consider some of the pros and cons of each and conclude with some takeaways for you to consider.
The decision when to incorporate (if ever) will likely involve in-depth research in conjunction with your chartered professional accountant (CPA), but here are some basics to get you started:
Incorporation Vs. Sole Proprietorship
Sole proprietorship is the default designation for business owners. If you start a business tomorrow and don’t incorporate, you are the sole proprietor. As sole proprietor, you and your business are one and the same. You simply report your business earnings as part of your personal taxes.
Incorporation separates you from your business. A corporation is its own legal entity. Once you’ve incorporated your business, you’ll file your business’s taxes and also your own personal taxes. You’ll also be paid a salary from the corporation or withdraw dividends as a shareholder.
The Pros of Sole Proprietorship
The advantages of sole proprietorship are mainly financial. Even if you formally register your business (which you don’t have to do), the annual costs are low.
It Costs Nothing To Start
Want to start a business tomorrow? Go for it. As long as you declare your business income on your taxes, you are now a legal business owner. Many sole proprietors opt to open a business chequing account at their bank and purchase insurance (especially for higher risk businesses). But, while advisable, these actions are not actually legal requirements of sole proprietorship.
The Overall Cost Is Lower
Aside from start up costs, the annual maintenance expenses associated with sole proprietorship are minimal. You won’t be obligated to pay annual fees, file annual reports, hold shareholder meetings, or work with a registered agent.
Cons of Sole Proprietorship
Sole proprietorship may provide upfront savings for your business, but it also comes with some disadvantages:
You Have Unlimited Personal Liability
This is a big one. Because you are your business, you’re personally liable for any debts or legal payouts that can’t be covered by your business. Unfortunately, this means your personal assets may be put at risk.
Every Dollar Gets Taxed
Because you receive all the profits from your business, you’re taxed on them as personal income. Taxes on personal income are generally higher than taxes on corporate income.
It’s More Difficult To Grow
Sole proprietorship doesn’t have anything to offer in terms of corporate structure. Bringing on partners or investors or hiring employees can become messy and disorganized very quickly. Also, many potential investors don’t want to open themselves up to the risks of unlimited personal liability.
You Only File one Tax Return
If your business sustains losses, this may be an advantage. But no one wants to count on that!
The Benefits of Incorporating
Incorporating isn’t always the right option, but it does come with a lot of advantages. Let’s take a look:
When you incorporate, you have much more control over your personal tax strategy. Depending on how you pay yourself and how much annual income you need to maintain your lifestyle, you can leave assets within your corporation and not pay personal income taxes on them until you withdraw them. Your CPA can also walk you through many other potential corporate tax advantages in more detail.
Your Home and Retirement Savings Are Protected
When you incorporate, your personal assets are no longer on the hook for business debts and fees. Known as limited liability protection, this is one of the primary reasons why many businesses ultimately decide that incorporating makes sense.
When it comes to financing, lenders, investors, and partners are all easier to procure when you own a corporation. Incorporation lends credibility and professionalism to your business. It also eliminates the risk of personal liability.
Disadvantages of Incorporating
Higher Operating Costs
When you incorporate, you’re legally responsible for maintaining your business’s finances according to stringent compliance requirements. Among other things, you must appoint a registered agent, hold shareholder meetings, file annual reports, and maintain specific records. All of this adds up to higher operating costs.
Filing Taxes Can Be More Complex
Though incorporating can come with tax benefits, it also complicates the tax filing process. Once you incorporate, it’s likely you’ll need a professional accountant to assist you at tax time and throughout the year.
When Should I Incorporate My Business?
There’s no definitive answer to this question and it’s best to talk over your unique circumstances and goals with your CPA. That being said, here are examples of a few instances where incorporating is strongly recommended no matter what:
When You Want To Grow Your Business
As mentioned earlier, sole proprietorship is not really a suitable option for a growing business. As your business becomes bigger and more complex, you’ll want the security, structure, and legitimacy that incorporation can offer.
When You’re Planning on Selling Your Business
When your business is on the market, you’ll find that many prospective buyers prefer it to be incorporated. Incorporated businesses have clear financial records and less potential liability moving forward.
When There’s a Degree of Danger or Risk to Your Business
No one likes to think about their business being sued, but if you’re in a higher risk market it’s something you definitely need to keep in mind. Incorporating your business can help you to protect your personal assets in the event of a worst case scenario.
In the end, there’s not necessarily a perfect moment to incorporate and every situation is unique. Incorporating comes with many advantages, but only you can ultimately decide whether or not the time is right for your business.
At Compass Accounting, we’ve advised many clients in your shoes and can offer our expertise to help you come to a final decision. For personalized financial business consulting, reach out for our Winnipeg accounting services today!