Should you incorporate your Canadian small business?
Many new business owners contemplate whether to incorporate their businesses. As an entrepreneur in Canada, you can run a business as a sole proprietorship, a corporation, or a partnership. You can change the legal structure of your business as it grows, so keep in mind that your small businesses may start out as sole proprietorship or a partnership and incorporate later on.
There are both advantages and disadvantages to incorporation in Canada. A corporation is a business entity that is independent of its owner(s) and does not pass on either its income taxes or its liability to owners. Is this type of legal structure the right move for your small business, right now? Let’s take a look at the pros and cons of incorporation.
PROS of Incorporation
The biggest advantage to incorporating your small business is the limited liability protection. Unlike a sole proprietorship, when an owner assumes all the liability of their company, when the business becomes incorporated, the owner’s liability is limited to the amount they have invested in the business. Incorporation makes it much more difficult for someone to go after your personal assets if the business defaults on debts.
Potential Tax Deferral and Savings
Operating your business as a corporation instead of a sole proprietorship can help to defer and save taxes. It’s common in Canada for a (private) corporation to be owned by a controlling shareholder who is an owner-manager. Business tax rates are lower than personal tax rates, so depending on whether your individual marginal tax rate is high enough (the combined federal and provincial taxes you pay on all sources of income at tax time), and if you don’t need those funds personally, you can leave that money in the business, and then take it out later when your personal tax rate is lower. However, when you take those funds for personal use, your company pays a dividend to you, and you will pay the tax at that time.
The more money you can keep in your corporate account, the bigger the tax benefit will be in the long term. But, there may be a time when you need to withdraw money from the corporation. As we know, illnesses, babies, and worldwide pandemics happen. Ideally though, you should keep as much money in your corporation as possible (after paying yourself a reasonable income) because otherwise it would be taxed at a higher personal rate. When you’re not working (a creative overseas sabbatical in a post Covid-19 world?), you can withdraw money from the corporation in a lower personal tax bracket and save on taxes.
For many small service companies, keeping the business lean and growing organically is the way to go. But, sometimes bootstrapping just isn’t enough. What if short term cash flow issues interrupting your growth? What if you need to scale up? Corporations are able to raise money more easily than a sole proprietor can, which makes it easier for your business to grow and expand.
Self-assess your resources, as financing cash flow is somewhat unique for each small business depending on the industry, stage of business, and the owner’s resources. Then speak to your accountant to discuss which type of loan is best for your business. They’ll ask you about your obstacles and suggest solutions depending on what type of money you will need. To learn about what options are out there, click our article on Financing Cash Flow.
The Lifetime Capital Gains Exemption
The LCGE provides owners of Canadian Controlled Private Corporations (most small incorporated businesses in Canada) with tax-free capital gains of up to $883,384, as of 2020. The amount increases every year.
How does it work?
For example, John runs a well known Tattoo Parlour (rented space) with a couple of employees and an annual revenue of $850,000. John, who wants to retire, finds a buyer who is willing to pay $860,000 for the shares of his corporation. But, since John grew his business from scratch, the cost of the business is $0. This means John has a gain of $860,000 on the sale. If he had operated his business as a sole proprietor, the $860,000 would be a taxable gain, and he would have to pay roughly $200,000 in taxes. But, since John operated his business as a corporation, he qualifies for the LCGE and the $860,000 gain is exempt from taxes.
CONS of Incorporation
There are costs involved with setting up a corporation, if you have someone who knows what they’re doing to help guide you. Of course, you could look after the incorporation of the business yourself for cheaper, but keep in mind that mistakes can be costly. You can choose whether to incorporate at a Provincial or a Federal level. Federal incorporation allows you to do business under the same name all across Canada. It’s less expensive upfront, but a bit more work to set up and maintain. It also requires a yearly filing on top of a provincial incorporation.
Continued Complications and Costs
You’ll also have additional ongoing costs with running a corporation too, including legal and accounting fees. There will also be added administrative tasks, due to record-keeping and bookkeeping: regular corporate tax instalments, annual corporate tax returns, separate bank accounts, and much more. If the idea of taking on paperwork, reporting, and filing tasks gives your creative brain some pain, consider hiring a pro bookkeeper. Not getting around to the details of bookkeeping, and then falling behind, will really cause you to suffer. Up-to-date bookkeeping is a map of your business that provides clear navigation to success. When you can easily review the details of where you’ve been, you can plan where you’re going with accuracy which relieves stress and gets you excited about the future.
That big advantage of incorporating—limited liability protection—is irrelevant if no one will give your corporation credit. What if lending institutions say that your corporation has insufficient assets to secure debt financing? What if you haven’t been in business long enough? What if you don’t have enough annual revenue? What if your personal credit score isn’t high enough? Lenders often insist on personal guarantees from the business owner(s). So, even though your corporation technically has limited liability, you might still end up being personally liable if the business doesn’t meet its repayment obligations.
Should You Incorporate Your Small Business?
Even after going over the pros and cons of incorporation, it can be a struggle to decide whether to incorporate your business or not. Many people just assume that incorporating is the best way to go because it seems like the benchmark for running a business. That’s not always true for everyone. Do you value limited liability protection, potential tax deferrals and savings, and the ability to raise funds? Can you tough it out if a lender won’t give you credit? Will you be able to afford the ongoing costs and complications that running a corporation brings? These are all questions to consider carefully. There are many businesses out there where the owner really is the entire business. In those situations, there may not be much motivation to incorporate. But, if you are hoping to sell your business eventually, then incorporation can save you a lot of tax.
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