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 you often hear is, incorporation is always good because it delivers terrific tax benefits while creditor-proofing your 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 advantages. The money retained in the company can be used to grow the operations or invest 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 flow through to shareholders. In those early stages, you’re generally 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 (in some provinces) and the opportunity to defer part of your tax payment. A Canadian controlled private corporation’s active business income is taxed at a relatively low combined federal/provincial rate of 9–15 per cent, depending on the province in which you’re doing business. The lower rate is generally applied on the first $500,000 of active business income. 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.
- There are many benefits to incorporation but determining first whether incorporation is right for you is important.
- Incorporation can provide tax advantages, depending on how profitable your business is.
- Incorporation may not protect you from all creditors, such as banks and corporate suppliers, who may require you to personally guarantee any liabilities.
Income splitting has historically been one of the big advantages of incorporation, but it has become more complicated since the expansion of the Tax on Split Income rules - but opportunities still exist. Income splitting is still possible, particularly if your family members work in your business or your business is not predominantly earning its income from providing services. There is also an ability to income split with a spouse once the business owner/shareholder reaches age 65, so retirement planning can factor into the decision to incorporate.
Incorporation may offer additional tax planning opportunities. 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 corporate year, yet the recipient only has to declare the income in the year it is received.
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 corporate 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 (RRSP).
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).
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.
Other important considerations
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