08/01/2023
To Incorporate, or not to Incorporate, that is the Question!
Over my 25 years in practice one of the most common questions I get asked by people who are starting a business is if they should incorporate or not. Or sometimes more generally, what business entity they should be using as they launch their new business. And as with all good questions, the answer is, it depends!
Before launching into my thoughts on when it may be appropriate to incorporate or not, let’s start with a brief overview of the business structure options Canadians have when starting a business, or at least the common ones. Yes, that means there will be no love for ULC’s in this post.
There are generally three options when starting a business in Canada in terms of entity selection: sole proprietorship (sole prop), partnership or corporation. There are some more complex structures and entities but for most businesses these three options are the most common.
A sole proprietorship is a business being run by an individual. There is no legal distinction between the person and the business. The income and expenses of the business are reported on the individual’s personal income tax return at the end of the calendar year along with all other sources of income and income tax is paid based on personal tax rates. The proprietor pays tax based on the net income for tax purposes of the business, not on how much they take out of any business bank account to cover personal expenses. Even though there is no legal distinction between the proprietor and the business, it is possible to register a business name for a sole prop, which allows things like bank accounts to be opened in the business name instead of the proprietor’s personal name. Or if appropriate you can simply use your name.
Partnerships exist where two or more taxpayers come together to operate a business or participate in an adventure or concern in the nature of trade. I love that phrase! The Income Tax Act isn’t quite Shakespeare, but it has its moments. Like a proprietorship, the income and expenses of a partnership are generally taxed on the partner’s tax returns. If the partnership is small enough and doesn’t include any corporate partners, then it doesn’t need to file its own partnership return. However, if it doesn’t meet the filing exemptions a partnership will need to file its own tax return each year, even though it isn’t taxable itself. In the case that no return is needed each partner reports the total income and expenses of the partnership on their return, then are taxed on the portion of the taxable income which they are entitled to under the partnership return. If the partnership must file a return, then each partner will receive a T5013 form to use to report their partnership income on their return.
Finally, we come to corporations! A corporation is a legal entity distinct from its owners who are called shareholders. The corporation must file its own corporate income tax return, called a T2, each year. In order to prepare the T2 the business owner must keep a set of books for the corporation which includes a balance sheet and an income statement. That is the basis of the corporate tax return. Since the corporation is a separate legal entity one of the main advantages of incorporation is referred to as limited liability. This means that the owners of a corporation in most instances cannot be held liable for the liabilities of the corporation. This would include liabilities which arise from legal action, though there are some ways in which the limited liability can be pierced. When owners take funds from a corporation they must be separately taxed on those funds as either a dividend or salary taken. Most Canadian owned corporations which operate in Canada have available to them what is called the small business deduction. This allows the first $500,000 of taxable income in a year to be taxed at a lower rate of tax, and most provinces have a similar provision. In Ontario for example a small business corporation which is a Canadian Controlled Private Corporation (CCPC) will pay tax at 12.2% on the first $500k of taxable income.
So, which one should you choose as you begin to build your fledgling business empire? Well, as stated at the start, the answer is it depends. On what you ask? On oh so very much of course! But below are some things to consider.
Will you have other sources of income when starting the business? Such as keeping a full time or part time job while starting out. Does your business plan (yes, you should have a business plan!) project that the business will have losses for a period of time before breaking even? If the answer to both of those is yes, then you may want to consider a proprietorship. The losses incurred can offset the other income earned and result in tax refunds until the business starts turning a profit.
Is the business in an industry that has high risk in terms of potential liability? This could include industrial businesses, anything involving heavy equipment or food services etc. If so then it may be worth incorporating right out of the gate to have the limited liability protection.
Is the business earning or projected to earn more money than you as the owner need to live off of? If so, then you may want to incorporate. The excess profits are taxed at the lower tax rate, resulting in a tax deferral. Long story short, this can give the owners of incorporated businesses an advantage in saving money for the long term due to the tax deferral.
Is cashflow tight to begin and the business profits will likely be needed just to cover living expenses? If so, then it may be worth starting as a proprietorship. This is because incorporating requires fees and professional fees to set up and to do the annual compliance filings. A proprietorship carries lower up front and annual costs.
These are just some common considerations. There are many more that could apply to different people in different situations. Fortunately, the decision isn’t one that can’t be changed later. While it comes with its own slew of tax and legal work and fees to do, a sole prop or partnership can be rolled into a corporation at a later date, when it makes sense. Alternatively, it is possible to roll the assets out of a corporation and reconstitute the business as a sole prop or partnership, although there may be more taxes owing in this second case than the first which can generally be done tax deferred.
As you can see, starting a business, even choosing what entity to use out of the gates can be a complex decision. This is why it’s important to find an educated, experienced business advisor to help you along the path. While it may be viewed as just one more expense to add in at the beginning, making the best choice for you will more than offset any initial advisory fees.
I hope you’ve found the above informative and possibly thought provoking. If you are starting a business and need assistance in navigating the many start up questions and choices which need to be made, feel free to reach out.
