Incorporation—now, later or never?
If you're like most unincorporated small business owners, you're likely contemplating these thorny questions: Should I incorporate? If so, when's the best time? If not, why not? The simple answer is, “Incorporation is always good because it delivers terrific tax benefits while creditor-proofing my personal finances.” But like all simple answers, this one is much too simplistic. Whether or not to incorporate raises a diverse array of issues—many of them having to do with the length of time you've been in business, your personal cash flow needs, the relative profitability of your business, and the personal and corporate tax rates in your province. Let's take a closer look at how these and other issues might affect your decision.
Cash flow and you
If you need all of the profits from your business to support your personal cash flow needs, incorporation may not be for you. The cost of setting up and maintaining the corporation could outweigh the tax benefits. But when your financial position allows you to retain some of your business profits inside the company, incorporation could deliver significant tax savings. The money retained in the company can be used to grow the operations or invested in other non-related investments.
Taxing questions and answers
When it comes to taxes, incorporation can be a double-edged sword. If you're in the initial stages of your business, it's usually advisable not to incorporate because losses incurred by an incorporated business can't be flowed through to the shareholders. In those early stages, you're better off being able to use those losses personally against other income.
Once your business becomes profitable, incorporation can provide tax advantages. If your business earns active business income (income earned as a direct result of the operation of the business as opposed to passive income earned, for example, by holding other investments through the corporation) you may gain an immediate tax break and the opportunity to defer part of your tax payment.
A Canadian controlled corporation’s active business income is taxed at a relatively low combined federal /provincial rate of 18–21 per cent, depending on the province in which you’re incorporated. That rate is assessed on the first $200,000 of active business income—a threshold that is scheduled to rise incrementally over the next few years. Even though shareholders must pay a second level of tax once the after tax income is paid out as dividends, this second level of tax is applied only when the dividends are paid. So you can control when you pay these taxes—and potentially reduce your tax bite—by choosing to declare dividends in years when your personal taxable income is lower.
Where your incorporated business is located can further reduce taxes. Certain provinces—Quebec, Nova Scotia, Newfoundland and Labrador and British Columbia—provide a corporate tax holiday for the initial years after incorporation and, while the amount of reduction varies depending on the province of residency, the 18–21% tax rate is effectively reduced for a few years.
Incorporation also allows you to take advantage of income splitting to reduce taxes. If your spouse or adult children are shareholders in your corporation, any dividends they receive will usually be taxed in their hands. Your corporation can also employ your family members as long as their remuneration is reasonable for the work performed.
You can defer certain expenses as well. For example, an incorporated business can report an employee bonus for tax purposes but may defer actually paying out the bonus money until after year-end. In order to be deductible in the year by the corporation, it must actually be paid to you no later than six months after the end of the year.
Creditor-proofing personal assets
Incorporation can limit your liability because corporate assets and personal assets are kept separate and corporate creditors can only go after assets owned by the corporation. But banks and other corporate suppliers often require small business owners to personally guarantee any liabilities and directors of a corporation may be liable for many types of unpaid debts (including outstanding income tax, GST/HST, PST and employee source deductions) so incorporation may not protect you from all creditors.
Retirement and insurance benefits
Your corporation can create a registered pension plan (RPP) and tax-deductible group health and life insurance for you and your employees, which could include family members. This pension plan option may provide higher retirement benefits than those available from investments in a registered retirement savings plan (RSP).
A year of your own
Your incorporated business can choose a fiscal year spanning any 12-month period. You can select a fiscal year-end that coincides with business or cash flow peaks (making tax payments easier) or when corporate expenses are higher (potentially reducing your corporate tax bite).
Estate planning
The life of an unincorporated business usually ends with the life of its proprietor. But a corporation can continue to exist indefinitely, which is why corporations are often used for estate planning purposes. It is important to take steps so that after your death the business remains profitable with sound management provided by family members or others.
If after assessing the pros and cons, you're leaning toward incorporation, you still have a few important decisions to make:
- Who will be the shareholders? You may choose to make family members shareholders for income splitting purposes— but the ability to issue shares to family members is limited in certain corporate structures. It's also not advisable to issue shares to minor children so it may be necessary to establish a family trust to hold the shares on their behalf.
- Who will be on the board of directors? Directors have exposure to many different types of liabilities, so becoming a director is not a decision to be taken lightly.
- Who should be the officers? These are the people entitled to sign contracts, banking, and other documents on behalf of the corporation. They must be chosen with care and with an eye to the future development and direction of your business.
Yes, there are potential benefits to incorporation, but be sure to seek financial advice before you make the final decision.
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This article, written and published by Investors Group Financial Services Inc., is presented as a general source of information only and is not intended as a solicitation to buy or sell investments, nor is it intended to provide professional advice including, without limitation, investment, financial, legal, accounting or tax advice. For more information on this topic or on any other investment or financial matters, please contact your Investors Group Consultant.
© Copyright 2007, Investors Group. All rights reserved. Do not reproduce without the express written consent of Investors Group.
