The decision to incorporate your business in Canada is a complex one. One way to help simplify it is by understanding the pros and cons of incorporation. With a little planning, you can rest assured about making the correct decision, and be well positioned for success in the long-term.
Advantages of Incorporating Your Business
Limited Liability
Liability is one of the more common reasons why people choose to incorporate their small business in Canada. Operating your business through a corporation provides a layer of security against personal liability as it makes it more difficult for creditors to go after your personal assets if the business is struggling and defaults on its debts.
If the business operates as a proprietorship, your personal assets such as your house and car can be seized to pay for the business’ debts. If you are operating your business through a corporation, liability is limited to assets held within the company. Your personal assets would not normally be at risk should the business fail to pay its debts.
Incorporation can often save the business owner from personal financial ruin. However, it is important to note there are circumstances where directors of incorporated businesses can remain personally liable for the debts of the business. The most common of these are:
Unpaid employee wages and vacation pay
Payroll remittances still owed to the CRA
GST/HST that has been collected by the corporation but was not remitted to the CRA
Banks and other debtors often require a personal guarantee for early-stage corporate businesses, meaning you would still be personally liable for the debts.
Taking on Investors
Oftentimes, startups with no revenues look to take on investors to fund the business plan. Once you begin adding investors, it may be advantageous to incorporate, otherwise, you would enter into a partnership structure by default. Partnerships may be appropriate in some circumstances, but are less common for investor relationships. By incorporating, you can also assign specific shareholder rights for different investors, including setting the cadence on how business profits are shared.
Tax Savings and Deferral
Corporate tax rates for small businesses in Canada can be quite low when compared to personal tax rates. Operating your business through a corporation provides more flexibility in how and when income is earned, thus providing the opportunity to save or defer tax. There are many factors to consider when contemplating the tax effects of incorporating, including how income is earned, how much the business is expected to grow year-over-year, as well as how you choose to have it distributed to you every year.
Surplus Cash
Another tax deferral benefit is when the business earns more cash than you need in a given year. If your business is earning more than you need to support your lifestyle, you can leave the extra cash in the company. This means only the lower rate corporate tax is paid on the excess, and not the higher rate of personal tax. The additional tax is deferred (not avoided) until it’s withdrawn from the corporation and paid out to shareholders in the form of wages or dividends sometime in the future.
Note that if the excess money within the corporation is used to buy other income-producing assets, then personal tax would never have to be paid on those funds. The ability to use deferred tax dollars to grow your business, as well as the ability to plan out personal income to take advantage of lower marginal tax rates can be great advantages to incorporation.
Lifetime Capital Gains Exemption (LCGE)
The LCGE provides owners of qualified small business corporation shares in Canadian Controlled Private Corporations (most small incorporated businesses in Canada) with tax-free capital gains of up to $883,384 in 2020 ($866,912 in 2019).
Some specific criteria have to be met for the LCGE to apply, which can be simplified as follows (details can be found on the CRA website):
Asset test - 90% or more of the company’s assets must be used in active business (i.e., not holding passive investments) at the time of the sale.
Basic asset test - 50% of the company’s assets must be used in active business (i.e, not holding passive investments) for the entire 24 month period before the sale.
Holding period test - The owner of the business must have owned the shares for at least 24 months before the date of the sale.
Typically, it’s quite easy to meet these criteria and be tax exempt on the gains from the sale of your small business.
Estate Planning
A corporation is a separate entity to the business owner, so it continues to live on regardless of what happens to you. This can be helpful when planning over a longer-term to transfer your assets to others, and provides flexibility when building a lasting business to pass onto the next generation.
The corporation has the same rights and obligations under Canadian law as a natural person, meaning it can acquire assets, obtain loans, and enter into contracts. A corporation continues to exist even if the business owner passes away. If that were to happen, ownership of the business would transfer to the shareholder’s heirs. This is not the case for partnerships or sole proprietorships, which cease to exist on the death of their owners.
Income Splitting (now limited)
Income splitting used to be a major reason for incorporating your small business. Before 2018, dividends could be used to distribute business income to a lower-income spouse, who would then be taxed at a lower rate. Since 2018, regulatory changes (called a tax on split income, or TOSI) have significantly limited the ability to use this technique. The rules apply when the income recipient is an adult family member and has not made a sufficient contribution to the business (essentially, working an average of 20 hours per week in the business). Dividends to these inactive members are taxed at a high rate, therefore the benefit of income splitting under a corporate structure has been significantly reduced.
Disadvantages of Incorporating Your Business
Incorporation Costs
Incorporation does cost additional money, mainly because it is associated with starting a company. These can include:
DIY incorporation - Depending on where you incorporate (federally or provincially), you can choose to incorporate the business yourself, with costs ranging from $100 - $400.
Lawyer assisted incorporation - You can hire a lawyer to incorporate your business, and the costs will typically range between $1,000 and $2,000, but may be higher depending on location and level of complexity.
Shareholder agreement - If your busines has other investors or business partners, it may be worthwhile to be hire a lawyer help create a robust shareholder agreement. This will give you recourse if there are any disputes in the future. The cost of this will depend on the lawyer and the complexity of the arrangement, but will range between $500 and $1,000.
Ongoing Costs
You’ll have additional ongoing costs associated with your incorporated business, which can include:
DIY annual legal filings - Legal filings have to be made to stay in good standing, and can be done for around $50 to $100.
Lawyer assisted annual legal filings - You can pay a lawyer to look after your legal filings on behalf of the company, and costs will range between $300 and $400.
DIY corporate tax filings - income tax returns have to be filed annually, can be done online or via off-the-shelf tax prep software for about $250 per year.
Accountant assisted corporate tax filings - You can pay an accountant to file your corporate tax return, and depending on the complexity, the costs will range between $1,500 to $2,000 range.
Administrative Burden
The corporation requires legal and tax filings each year to remain in good standing, which requires attention and is a time commitment for the owner. If you’re allergic to paperwork, the extra administrative burden may require you to hire expensive professionals more often if you operate your business through a corporation. Also, when shutting down the corporation, there is a whole other checklist you’ll have to run through to end things properly.
100% Owner-operated Businesses
There are many businesses out there where the owner really is the entire business. In these situations, there may not be much motivation to incorporate. Typically if the business is not being built to sell, is in a low-risk industry, and earns just enough for the owner to live on and save for retirement, then there may be limited benefits from incorporating, and the additional costs and administrative burden of incorporation can also be avoided.
Applicability of Losses
If your business sustains financial losses, it is more difficult in a corporation to use those losses to reduce future taxes. It’s not uncommon for start-up businesses to incur losses at first. When you operate a proprietorship and incur a loss, you can deduct that loss against your other personal income. If you were operating that same business through a corporation, the loss could not be applied to your personal income. Instead, the loss can be applied to another year’s corporate tax return to reduce tax within the company only.
The company could carry the loss backward up to 3 years to receive a refund of some previously-paid taxes, or carry the loss forward up to 20 years to reduce taxable income on a future return. The benefit is losses can reduce corporate income in other years. This is less helpful than it would be to have the loss directly reduce personal income taxes in the current year.
Expecting Losses
Some businesses take a while to get off the ground. It’s not uncommon to see businesses operating at a loss for multiple years before taking off. If the loss is incurred through a sole proprietorship, you can apply that loss against your other income to reduce personal taxes. If the business was incorporated, the loss could only be applied against future corporate income.
Pay More Taxes
It is uncommon for a corporation to pay higher taxes overall, but in some scenarios, the small business deduction may not be available to corporations, thus resulting in a higher tax rate. In addition, personal tax credits available to unincorporated business owners can mean a proprietorship pays less tax than a corporation.
Real Estate Rental Business
Operating a real estate rental business can be a great way to earn income and create wealth. In many cases, there is no tax advantage to operating a real estate rental business through a corporation. Until the business becomes quite large (employs more than five full-time employees), the rental income earned through the corporation is classified as investment income. Investment income is taxed at a higher rate than business income because the small business deduction does not apply. This has just removed one of the main benefits of operating a Canadian Controlled Private Corporation. There are a couple of other reasons why it can be better to own real estate personally instead of through a corporation:
It is often easier to obtain a mortgage personally than through a corporation, and
If you live in the property before or after renting it, you could use the principal residence exemption to reduce some capital gains tax upon the sale of the property.
There are always other factors and scenarios where owning real estate through a corporation may be beneficial, but the typical preferred route is personal ownership for property holdings when less than six full-time employees are working in the business.
Schedule a meeting
Even after reviewing the pros and cons, it may not be easy to determine whether you should incorporate your business, when is the right time to do it, and whether there actually are any tax benefits. New business owners often incorrectly assume that incorporation is the preferred route because it appears to be the gold standard for running a business, but sometimes it may be better to operate as a proprietorship.
At Arria CPA, we deep-dive with our clients into the various relevant factors that help decide whether to incorporate their business. Contact us for a free, no-obligation consultation to learn more about how we can help you start your business on the right foundation.
Disclaimer: Please note that this is only a brief summary and is based on current accounting regulations and tax law interpretations. Accounting regulations and tax laws are subject to continual review and change, so should the facts provided to us be inaccurate or incomplete, or should the law or its interpretation change, our summary may be inappropriate for your uses. This article is written for educational purposes only, and as such, we recommend you consult a professional before making an accounting or tax decision. If you have any concerns, or would like further consultation regarding this matter, please contact us.
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