To Incorporate or not to Incorporate: Key Tax & Technical Considerations

Open sign representing when to incorporate a business

Starting a business can be very rewarding. But knowing when or if to incorporate your business can be tricky to ascertain. Today’s post highlights the important points to consider when answering the incorporation question.

What does it mean to incorporate?

Firstly, let’s define incorporation: incorporation is the creation of a separate new legal entity: your business will become a separate entity from the owner. In contrast, a sole proprietor is not distinct from the business they are running – they’re one whole. After incorporation, a business will have independent legal rights under the Canadian Business Corporations Act (“CBCA”), if incorporated federally, or the provincial Business Corporations Act, if incorporated provincially. The legal rights include:

  • the right to carry on a business,
  • the right to enter into contracts, and
  • the ability to incur legal liability.

At the same time, it should be noted that when the business exercises these rights, these acts are done on behalf of the corporation, not the owner.

Now that we’ve defined the incorporation piece, let’s look at key considerations. The list noted here is not meant to be exhaustive and should be used as guidance only.

Liability protection

One of the biggest advantages of incorporation is the protection of personal assets because incorporation limits the liability of a corporation’s shareholders. Simply put, the shareholders of a corporation are not responsible for the corporation’s liabilities unless they have specifically signed a personal guarantee. It should be noted however that if a shareholder is also a director, that person could be liable for the corporation’s liabilities in their capacity as a director. Notwithstanding, generally, the risk of personal loss is limited to the amount invested into the corporation.

Tax Benefits

As you may already know, many incorporate because of the tax advantages that it presents. The common advantages include:

  • Corporate and personal tax rates differ (with the corporate rate being considerably lower),
  • The ability to defer taxes,
  • Income splitting, and
  • Lifetime capital gains exemption.

Tax Deferral

Corporate earnings are taxed at a corporate level, but once distributed to the shareholders, earnings are then taxed again at the shareholder level. When a business is incorporated, the shareholder can defer personal taxation on the after-tax earned income until it is withdrawn from the corporation. Before we jump into the further advantages of this, we need to explain why the corporate tax rate is usually lower than the personal tax rate.

Tax Rate Differential

In Canada, a corporation that is incorporated under Canadian laws and is controlled by Canadian residents will normally qualify as a Canadian-controlled private corporation also known as a “CCPC” (there are other criteria under the Income Tax Act (the “ITA”), but for the sake of simplicity, let’s go with this basic definition). CCPC status allows a business to claim the small business deduction (the “SBD”), which applies a reduced rate of tax on the first $500,000 of a corporation’s annual taxable income earned from carrying on an active business in Canada (the income has to fall under the ITA definition of “Active Business Income”).

If a corporation qualifies for the business deduction, it pays a tax rate of approximately 11 – 16% on that first $500,000 of taxable income (depending on the province and other factors). As such, the corporate tax rate on business income is generally lower than the shareholder’s personal tax rate.

Going back to the topic of deferral, since the corporation has lower tax, keeping the earned business income inside the corporation may result in less immediate taxes payable, thereby deferring tax, and allowing funds to accumulate within your corporation, which can then be used to re-invest in the business and earn additional income.

What happens when business income is withdrawn from the corporation?

Business income is generally withdrawn via dividends, at which point the balance of the tax is paid on the distribution and also, the shareholder pays tax at a personal level. The tax rate depends on whether the dividend is an eligible or ineligible dividend, ranging between 19% and 40% depending on the province. As evident, the tax savings afforded by deferral can be significant, if the earnings are left in the corporation.

Income Splitting Opportunities 

Another tax advantage of incorporating is the existence of income splitting opportunities. Income splitting happens by distributing business income via dividends to a lower-income adult family member (providing they are a shareholder in the business), taking advantage of their lower tax rate.

The Lifetime Capital Gains Exemption 

If you’re considering selling or transferring your business at some point, the lifetime capital gains exemption (“LCGE”) provides another advantage. The LCGE provides a tax break on the capital gains the shareholder can use upon the disposition of the corporation’s shares (there is a limit, which changes each year; subject to multiple conditions under the ITA). Therefore, when you sell your business, the LCGE can help shelter the gain from tax, up to the LCGE limit.

Capital Raising

Many start-up businesses raise money from investors and a corporation is the easiest form of business to raise money for, because it falls under a comprehensive legal framework such as the CBCA or OBCA. In exchange for capital, a corporation can issue equity (shares) or debt (bonds). In contrast, a sole proprietorship or partnership cannot issue any of the mentioned certificates and is limited to only one form of capital raising: a capital loan from a bank. This limits the options for growing a business.

Business Existence

A sole proprietorship only exists only as long as its “sole owner” is in the picture. A corporation, on the other hand, can continue indefinitely regardless of whether the original owners are involved or not. The ownership of the corporation could be transferred to other owners and the business continues as before, an option sole proprietorship or partnerships cannot offer.

The Disadvantages: Complexity & Cost

There are also a few disadvantages of incorporation, including increased complexity and cost. One has to adhere to a number of corporate formalities under the Business Corporations Act, regardless of whether you are a sole owner or not. Furthermore, a corporation is also subject to greater regulation and compliance. For example, the CBCA dictates that corporations must hold annual shareholder meetings and maintain corporate records, along with additional reporting and filing requirements.

With this added complexity comes the administrative, legal, and accounting costs associated with establishing and maintaining a corporation. These costs are much higher than those of a sole proprietorship. A corporate tax return must be filed annually, which is more complex, and usually requires the assistance of a professional.

So, in short, should you incorporate?

Ask yourself, does your business have a high level of business risk? Do you see yourself raising capital in the future from investors? Is your business producing more income than you need for your annual living expenses (i.e., can you afford not to take out income from the business)?

If so, then you should consider incorporating. By incorporating, you can limit the exposure of your personal assets, can issue consideration in return for invested capital to creditors and investors, and you probably have business income that can benefit from tax deferral.

CONSULT WITH A FINANCIAL PROFESSIONAL AT EDELKOORT SMETHURST SCHEIN CPAS LLP IN BURLINGTON FOR MORE INFORMATION

A skilled accountant will advise on the right time to incorporate your business. If you are a small business owner or a self-employed individual and wish to learn more about how to maximize tax benefits for your business, please contact the Chartered Professional Accountants at Edelkoort Smethurst Schein CPAs LLP in Burlington at 905-517-2297 or by contacting us online.