As a business grows and matures, many sole proprietors and small business owners are at some point faced with the question of whether or not to incorporate their business. There are several benefits to incorporation as well as disadvantages that small business owners should be aware of before settling on a decision. Firstly, what does it mean to be incorporated?
Incorporation simply refers to the formation of a new legal entity, where the company is essentially recognized as a person under the law. Corporations are often businesses - but not always. A corporation can also be a not-for-profit, a sports club or even a government of city or town for instance.
Now, let’s examine some of the pros and cons of incorporating your business.
- Limited Liability: This is probably the most significant advantage and likely the primary reason that most small businesses owners incorporate. Corporations are legally considered separate entities and as such any income or debt incurs belongs to it, not the owners. In the event that the business defaults on a loan or files for bankruptcy, they owners are not personally responsible, except when personal collateral was provided to secure a loan.
- Raising Capital: Corporations have the ability to raise money more easily than individuals, which makes it easier for your business to reinvest in growth and expansion. Corporations can sell off shares and raise equity capital, whereas sole proprietors can not.
- Optics: Whether or not your business is incorporated can actually impact how your operation is perceived by potential investors, partners and customers. Incorporation, along with the “Inc” or “LLC” designation that comes with it, provides an added level of legitimacy, confidence and perceived stability.
- Income Deferral: Being incorporated allows you the flexibility to opt for the most tax-efficient way to pay yourself. For instance you can determine when you can personally receive your income, which can be a serious tax advantage (i.e. you can pay yourself at a time when you’ll pay less tax).
- Income Splitting: Corporations are allowed to pay dividends to their shareholders from the company’s earnings. A shareholder does not have to be actively involved in the corporation which means your spouse and/or your children could be shareholders in your corporation, giving you the opportunity to redistribute income from family members in higher tax brackets to family members with lower incomes that are taxed at a lower rate.
- Tax Credits: Incorporated businesses may qualify for the Federal Small Business Deduction (SBD) which could reduce your net business tax rate to a much lower rate than what is applied to your personal income. The SBD is calculated at the rate of 17% on the first $500,000 of taxable income, which may reduce your net business tax to a much lower tax rate than that applied to your personal income.
- Costs: Setting up a corporation either provincially or federally can cost a few hundred dollars. Typically, the process of incorporation costs anywhere from $1,000 to $3,000 or more, plus additional legal or accounting fees as needed.
- No Personal Tax Credits: Every dollar a corporation earns must be taxed. As a sole proprietor, you may be able to claim tax credits that a corporation otherwise could not.
- More Paperwork: Corporations must file separate tax returns, an annual return, one-time articles of incorporation and notifications of share sales, moves or changes of directors. You will also need to file an annual corporate financial statement, which can cost $1,500 - $2,500.
- Less Tax Flexibility: A corporation doesn't have the same flexibility in handling business losses as a sole proprietorship. As a sole proprietor, if your business experiences operating losses, you could use these to reduce other types of taxable personal income in the year the losses occur. Also if you shut the incorporated business down, you can’t claim the company’s losses personally – they are gone. Alternatively, in a sole proprietorship, you may be able to claim the full amount of your business losses against other income.
- Process to Close: Closing a corporation requires a process which requires more paperwork and money. You must pass a resolution to dissolve the corporation, winding up payroll accounts, and sending a copy of the Articles of Dissolution to the Canada Revenue Agency along with the final tax return for the corporation