Should you incorporate your small business? (Sole proprietorship, partnership etc)
Jumping from Sole Proprietorship to Corporation in Canada? We’ll break it down step by step.
Earning side income or owning a small business can be a very rewarding experience, both emotionally and financially. The obvious perks of such a venture are unlimited earning potential and a whole lot more freedom and choice.
In Canada a business can operate as a sole proprietorship or a corporation. Often most small businesses operate initially as sole proprietorships and later incorporate for various reasons discussed below.
Editor’s Note: The same principles discussed in relation to sole proprietorships apply to limited partnerships.
- Lower Cost of accounting and administration fees
- Business is filed on a T2125 schedule on your personal income tax return
- You do not have to reconcile your bank or credit card accounts
- You do not have to declare your “personal use of company funds”
- Accounting method is simple and can be done in excel or from loose paperwork alone
- You do not need an accounting software
- No accounts payable or accounts receivable taken into account when filing
- Can have a GST # and can have a Payroll #
- Great for businesses with “NET” (after write offs) income of $30,000 or less
- Tax rate scales based on net income from 25-45% tax depending on which tax bracket you fall under
- Ex) After you’ve earned over $90k you’re looking at approximately 40%-50% tax on each additional dollar earned. Our tax system works like this to provide lower tax rates to low income earners and higher rates to higher income earners (in theory).
- At the end of each year you add up all the business revenue you earned in the year and subtract all the related expenses (note: you can deduct non-direct expenses such as office and vehicle expenses of a business on a pro-rated basis). The net income (earnings less expenses) is then used to determine the amount of tax you owe. For example, if you earned $50,000 and had $30,000 in expenses for a net income of $20,000 you would have a tax bill of approximately $4,000 [($50,000 – $30,000) x 20% tax rate].
- Restricted to January – December 31 st fiscal reporting period every year
- Net income is added to other taxable income for the taxpayer
- No deferral options, and minimal tax planning tools
- Higher risk of audit by CRA
- No accounts payable or accounts receivable taken into account when filing
- By default you do not qualify for EI on self employment earnings
- In Alberta no qualification for WCB which can limit working opportunities in industries such as trades and construction
- Harder to acquire Import/Export accounts & funding
- Higher lending rates and requirements are not strict
Sole proprietorships typically have the following government reporting requirements:
- Initial business registration (Declaration of a trade name and opening on a “business bank account” – Cost $45- $150
- Annual personal tax returns (T1) – Cost $150 – $1000
- Payroll remittances and filings (if additional employees exist besides the owner)
- Sales tax (if registered for GST/HST)
Very Limited Liability Protection:
Under a sole proprietorship the owner is personally responsible for all debts and liabilities and legal costs of the business. These debts may include credit cards, business loans or liabilities arising out of lawsuits. If the small business operating as a sole proprietorship is unable to fulfill these debts a creditor is almost certain to seek restitution through the forced sale of personal assets (house, car, investments) of the owner in court.
- Corporate Tax rate for NET income under $500,000 is a flat 15% in Alberta
- When NET income exceeds $500,000 – amounts above are taxed at an additional 38.5% tax. This is significantly lower than the 45-50% tax rate on the income equivalent through a sole proprietorship based on personal income tax brackets.
- Flexible “Fiscal” reporting period (Not restricted to January – December 31st)
- This gives you maximum flexibility to tax plan (For example place your year end during a “slow” season in your business)
- Lower risk of audit – with more defined rules for what triggers an investigation
- Additional options available:
- Declare Shareholder income as T4 Employment Wages or Dividends
- Access Income Deferral through use of “Bonuses”
- Borrow money against your own company and pay it back over extended periods of time at interest rates as low as 1%
- Purchase real estate inside the corporation
- Acquire assets in the business name – which reduces personal liability
- More readily available options for business lending and better interest rates
- For example: Easier to acquire vehicles, leases on equipment and other operating capital to fund advertising, business development or expansion expenses
- Easier to acquire fleets of vehicle and better rates for financing
- In Alberta a corporation is required to apply for WCB
- More favorable rates on business insurance (Errors and omissions, Liability and commercial rates)
- Easier to set up Import/Export accounts
- Higher Cost of accounting and administration fees
- Incorporation Fees range from $500 – $1500 depending on the structure
- Tax return for a corporation: T2, Financial Statements, Notice to Reader, Engagement Letter (Prices range from $350 – $10,000/year)
- May have increased reporting obligations such as a Review or Audit of year end statements in situations where the business activities require “Bonding” These can only be prepared by a qualified and approved CPA (Thus the higher price ranging from $3000 – $25,000)
- Higher government regulations compliance requirements: Requires reconciliations be done on all company owned accounts: Bank Statements, Credit card statements, loans & financing accounts
- Declaration of shareholder loan – responsibility for declaring money put into the company and money withdrawn from the company by the owners
- Requires more diligence from shareholders with emphasis on tax planning, budgeting & using ongoing cashflow & projection programs to ensure long term sustainability of the business.
Corporations may be subject, but not limited to the following reporting requirements:
- Setting up articles of incorporation
- Annual information return – this is a brief return that details information about shareholders and general information about the corporation (filed with the provincial government for a fee)
- Maintaining corporate records, which are separate and distinct from personal records (must be held for 6 years per CRA regulations)
- Filing an annual corporate income tax return which include detailed financial statements
- Payroll remittances and filings (if the corporation has employees)
- Sales tax – if sales of the corporation exceed $30k you must register for GST/HST and track sales tax spent and collected
Typically expenses written off by corporations can similarly be written off by sole proprietorships, however, a corporation allows for additional income splitting in certain situations which may lower overall taxation. For example, suppose a spouse is the shareholder of a corporation that manages the overall operations of the business. If the other spouse helps out the business with administration and other tasks a reasonable salary can be paid which can be written off by the business and taxed at a low personal rate.
Increased Liability Protection:
A corporation allows for an owner/shareholder to separate him or herself from the legal responsibilities of the business. If the corporation is unable to pay debts or liabilities the creditor or plaintiff may only seek assets owned by the corporation and not the shareholder. There are certain situations in which a shareholder may be personally liability, such as providing personal guarantees for corporate debts, remitting sales tax and payroll remittances, so talking with a knowledgeable lawyer is always a good idea.
Justification and advice on cost comparison vs value:
Often I see small business owners of both sole proprietorships and corporations attempting to skimp out on paying professional fees. Having run my own small accounting business myself, and having provided tax planning services in an accounting firm, I understand the value of these services is often difficult to quantify or justify, especially considering the cost of professional fees. However, I’ve also seen situations where personal and corporate bank accounts have been frozen by the CRA for non-compliance, or an unexpected tax bill cripples cash flow because these issues were neglected. There can be tax minimizing opportunities lost (such as tax deferral, income splitting and other deductions) by business owners when they fail to engage a competent accountant. Paying a competent professional can ensure a business handles these issues before they become massive problems.
The corporate small business tax rate in Ontario is 15% on the first $500,000 of income. Sweet sassy molassy, that’s way lower than the personal tax rates above. Why doesn’t everyone just incorporate? I know, right? Well, hold on there that rate is for income earned in the corporation and it must stay there until paid out to the owner via salary or dividends. This is where tax planning comes into play and can drastically affect your take home pay if you’re earning some decent money.
Here’s an example of a business earning $100,000 in income under the sole proprietorship VS corporation.
- NET Income: $100,000
- Taxes Payable: $26,600
- NET Income: $100,000
- Taxes Payable: $15,500
Now recall that for a corporation we have to pay a salary out to the owner in order for him or her to access the profits. If the owner wanted $70,000 in salary and wanted to leave $30,000 in the business for future investment it would look like this:
|Net Income||$100,000||$30,000 (reduced by $70k salary)|
|Business Taxes Payable||$26,600||$4,650|
|Employment Taxes Payable||$15,000|
|Total Taxes Payable||$26,600||$19,650|
By incorporating and paying a $70k salary the business owner would save close to $7k in taxes. If the business owner would live off a salary less than the net income of the corporation we can see considerable tax deferral and capital appreciation by leaving the funds in the corporation and investing. The Canadian corporate tax rate has decreased substantially over the last few decades to encourage business spending.
Final Decision: Incorporation: Is it right for you?
There are a lot of other considerations when thinking about incorporating a business. While the administrative and compliance responsibilities and costs are much greater under a corporate structure the benefits include liability mitigation of the owner, tax savings and estate planning. It probably doesn’t make sense for a small business with minimal operating risk and net income under $30k to incorporate as a low tax rate is already enjoyed. As a business grows so too do the tax liabilities and operational risk, which may indicate it’s time to prep those articles of incorporation. When a business reaches net income above $30k it may be a good time to discuss if it’s time for incorporation. Each business owner should consult with a lawyer and accountant to determine if the increased costs are offset by the benefits.