For most businesses, the question is not if, but when, to incorporate.
There are many pros and cons of incorporating a small business, depending a lot on individual situations. But too many businesses fail to revisit the question of whether to incorporate.
As your business matures, and the realities of your legal and tax situations change, asking the question again may bring a different answer.
The pros and cons of incorporating a small business can vary, but here are the most common:
Your business is a separate legal entity and as such, creditors or legal actions go against your corporation and its assets, not your personal assets. (There are exceptions, such as personally guaranteed loans, government tax obligations and payroll deductions, among others.)
Your business has tax flexibility from which you may personally benefit. If you sell shares in your Canadian-controlled private corporation (CCPC), capital gains could be tax-free up to $750,000.
You can choose the most tax-efficient way to pay yourself, including dividends, salary, bonus or a combination. You can even use dividends as a way to split income with your spouse if he or she is a shareholder in your CCPC.
If you don’t need all business earnings for personal income, you can leave them in the business, deferring personal taxes on withdrawals and possibly enjoying an approximately 15-per-cent preferred tax assessment on the first $500,000 of profit in CCPCs.
Incorporating costs money. You can do it on your own, technically, but it’s more advisable to get the help of a lawyer and an accountant.
Incorporated entities must file more paperwork, such as separate tax returns, an annual return, one-time articles of incorporation and notifications of share sales, moves or changes of directors.
Losses in an incorporated company can’t be personally claimed. A failed startup can only be “written off” personally to the amount you had invested, not the accumulated negative earnings.
I took my own advice and called on the professionals for more guidance on the incorporation question.
“Filing fees and professional fees for an incorporation can range from $800 to $2,800, so the cost itself maybe be prohibitive for some,” said Albert Luk, a lawyer with Devry Smith Frank LLP in Toronto.
“If you are starting a speculative business, with low liability and legal risks, and are likely to incur losses in the early days, postponing incorporation may make sense, primarily for the cost savings and tax advantages,” he added.
What did he mean by postponing? “As your business grows, the need to incorporate may become greater . So revisit the business case for incorporating periodically,” he advised.
Incorporating later in the life of a business is always an option but a little more expensive, depending on the complexity involved in transferring business assets into the corporation and registering the accompanying tax elections.
As for the accounting side, “as long as you remain a sole proprietorship, all your profits will be taxed as personal income, which could involve tax rates potentially as high as 46 per cent,” said chartered accountant Michael Machon of BDO Canada ‘s Cobourg, Ont., office.
“If you have a small business, earning, say, $60,000 or so, you may be fine either way. Once, however, you start earning well above that level, you may be missing out on ways to more effectively manage your taxes: income-splitting with family members and/or deferring income taxes, for example.”
Added Mr. Machon: “If you run an incorporated business at a loss and then shut it down, you can’t claim the business’s losses personally – they are gone. All you can claim personally is money you lent or invested in the business as stock or loans, whereas, in a sole proprietorship, you may be able to claim the full amount of your business losses against other income.”
Mr. Machon estimated accounting fees for incorporating a startup business at $1,000 to $2,000.
With this expert advice, when is it time to incorporate? The answer is: It depends.
A business with anticipated losses and little legal risk can likely start as a sole proprietorship, but increasing risk and more significant earnings will favour incorporating later on.
So when should your business incorporate? Keep asking that question until you grow into a different answer, and then you can quickly take action.