Many small businesses begin as sole proprietorships; they are relatively quick and easy to set-up. However, as your business grows, it’s important to assess whether this business structure is still the best for you. Maybe it’s time to incorporate your small business? Here are a few important considerations.
Advantages of incorporation:
- limited liability. This is the main legal reason for incorporating a business. Generally speaking, the liability of an individual shareholder is limited to the amount of money invested in the company (there are exceptions to this).
- tax flexibility. You can choose the most tax-efficient way to pay yourself such as dividends, salary, bonus or a combination.
- tax deferral. If you don’t require all of the business earnings for personal income you can leave them in the corporation, deferring personal taxes. This one is a bit confusing so here is an example. The concept of tax deferral stems from the fact that the corporate tax rate is lower than the personal tax rate. Let’s say you earned $125,000 personally, a portion of the earnings would be taxed at a rate of roughly 46%. If $125,000 was earned in a corporation (assuming earnings are less than $500K), the business would pay approximately 16%. The difference in tax rates (46% vs. 16%) is referred to as tax deferral.
Disadvantages of incorporation:
- Set-up costs. Although you can incorporate a business yourself, it is very important to take care when setting up share classes, determining shareholders and control. Therefore, it’s advisable to get the help of a lawyer.
- Administrative costs. Corporations must file their own tax return (called a T2) and an annual return. They must also maintain a minute book as well as up-to-date records of the directors, share register and articles. Overall, there is much more paperwork required with an incorporated business.
- Losses stay in the company. Losses can’t be written off against other income of the shareholders.
So, should you incorporate your small business?
If you’re operating in a high risk industry, it may make sense to incorporate your business when you start it. On the other hand, a business with little legal risk and expected losses or low income, is likely fine as a sole proprietorship. If the risk profile of your business changes and/or net income increases, it might be time to incorporate. From a tax perspective, there isn’t a specific income level at which you should incorporate. In general, if your business is earning more than you need as personal income, you’ll be able to take advantage of tax deferral.