I work with many new immigrants and small business owners and I find that many people have similar questions and misunderstandings of the Canadian tax system. This post will be part of a series which addresses some of these common questions.
This specific article may be useful if you are currently operating a business as a partnership or sole proprietorship. Issues or situations that would apply for a larger business may not be addressed here but feel free to contact us with any questions.
There comes a time for every business venture when the question comes up: Should I incorporate?
While incorporation offers many benefits, it is important to think about whether you will actually take advantage of those benefits. Below are just a few considerations.
1. Cost
Besides the annual T2 corporate tax filing fee, annual corporate return, and the legal fees to setup the corporation, there are also additional administrative and record keeping (ie. minute book) expenses which take up time and money. You should carefully consider these costs and whether they make sense at your stage of the business.
Another consideration is the cost of incorporating later on in your business. For example, if your business requires significant assets such as vehicles or real property, there may be additional expenses (ie. registration fees, land transfer tax, legal fees) in transferring legal ownership to the corporation. If there are significant valuable assets, a section 85 rollover might be applicable to defer taxes.
It can be hard to do a cost-benefit analysis on your own and a misstep could result in having to pay unanticipated taxes. Involving an experienced accountant or lawyer early in the process will save you headache and money in the future whether it is direct taxes saved or costly mistakes avoided.
2. Lower tax rates
While a corporation has a lower tax rate on its income, you should keep in mind that taking money out of the corporation is subject to taxation on your personal tax return. A fundamental idea of the Canadian tax system is that there shouldn’t be a tax advantage whether the income is earned in a corporation or by an individual.
Therefore, the Income Tax Act is written in a way where if you earned income in a corporation, then paid out a dividend to yourself, the amount you would end up with net of taxes would be approximately equal to the net amount if you earned the income directly. The real advantage of incorporating is in keeping profits in the corporation to defer the realization of taxes.
Alternatively, if the corporation paid you a salary, you would be taxed on that as well at your personal tax rate. To the corporation, the salary is an expense therefore it is not taxed. Again, the end result is that you end up with income taxed at your personal tax bracket.
This is why business owners who incorporate are even more incentivized to expense their spending using corporate accounts than those who operate a sole proprietorship. The corporate business owner can only take advantage of the tax benefits by keeping profits in the corporation; he needs to minimize the amount of dividends or salary he pays himself for personal expenses. You cannot expense personal spending through the corporate accounts (unless you want a nasty surprise in a CRA audit) but generally, any expense that can be linked to the business should be charged to the corporate account.
3. Personal income requirements
You may have personal circumstances that might require a certain amount of income on your personal tax filings. For example, if you plan to sponsor a family member to come to Canada whether for permanent residence or a Super Visa, the IRCC requires that the sponsor meet a certain income level. If you keep profits in your corporation, it will not show up as income on your personal tax return. Alternatively, if you pay out a salary from your corporation, you lose the benefit of the lower corporate tax rate. The IRCC may make exceptions to the income requirement but this is on a case by case basis and the documentation for the application becomes far more arduous. Please contact us if you are in this situation.
If you retain income in your corporation and have little if any personal income, you may also have difficulty getting a mortgage. In this situation a mortgage broker should be able to work with you on a solution but it does introduce another cost in structuring your business as a corporation.
4. Business losses
Many businesses operate at a loss for the first few years. Under a sole proprietorship, those business losses can be used to reduce other taxable income, such as employment income from another job. Business losses in a corporation are generally kept within the corporation. The losses can be carried forward (or backwards) to other years where the corporation has profits but you do not have access to these losses for your personal income tax.
Furthermore, if your business is operating at a loss, you cannot get the benefit of lower corporate tax rates!
5. Protection of personal assets from creditors
Canadian law recognizes that a corporation is a separate legal entity from an individual. This means that if your corporation goes bankrupt or an injured customer or tenant sues the corporation, they cannot go after your personal assets.* Depending on the type of business, this could be a significant factor in your consideration to incorporate.
6. Diversifying ownership
After your business is incorporated, you do not have to be the only owner. The shareholders are the owners of the business. You could have all the shares and retain 100% ownership or the shares can be given to family or sold to investors.
The ability to have multiple shareholders gives you additional flexibility in tax planning. The income from the corporation does not have to go to you directly, but other shareholders, such as family members who might have a lower tax bracket.
The ability to allocate ownership of the business to others also allows more estate planning options. The shares representing ownership of the corporation can be passed on to family members or sold. If the business was operated as a sole proprietorship, there would be no shares and individual assets would need to be accounted for and transferred, a process that could cost more in time and money.
Conclusion
These are only a few of the common practical considerations for incorporation. There are many other issues that might arise on a case-by-case basis which requires a consultation with an experienced accountant or lawyer.
*There are exceptions to this if the corporation is a sham where the courts can “pierce the corporate veil”,