Most small business owners eventually face the question of whether or not to incorporate their business by creating a limited liability company or “corporation”. Owners of small business corporations enjoy preferential tax treatment in Canada in the form of lower corporate tax rates, tax-free status on sale of small business shares and access to certain investment tax credit programs.
We have developed the following list of questions you can use to evaluate whether or not to incorporate.
1. Does your business face significant uninsurable liabilities?
2. Are you going into business with another person or group of people?
3. Is your personal budget lower than the expected earnings from the business?
4. Do you have a low income spouse who is inactive in the business?
If you answered “yes” to any of these questions, incorporation might be a good idea.
Does your business face significant uninsurable liabilities?
A corporation has a legal existence separate from its owners. The creditors of a corporation must pursue the corporation for payment and not the individual owners. This means the owners can be shielded from many of the liabilities associated with operating as a proprietorship or partnership. A good commercial insurance policy is the best first line of defense against operating liabilities; however, you need to consider what uninsurable risks you might face as a business owner and whether these risks are greater than the cost of creating and administering a corporation.
For example, a commercial building contractor faces significant indefinite risks for future warranty claims. It is generally considered prudent for such a business to be incorporated.
Some liabilities, such as payroll taxes owing to the government and certain environmental sanctions can attach to the directors of a limited company. You should obtain legal advice regarding the effectiveness of using a company as a shield in your particular circumstances.
Are you going into business with another person or group of people?
In our experience, whenever two or more people are creating a business together, incorporation is a good idea. Partnerships are generally more difficult to administer than corporations for a number of reasons. The only time we generally advise against early incorporation of a partnership is when significant start up losses are expected and the partners want to use these losses against their other source of personal income instead of carrying them forward against future business income.
In certain circumstances, a Limited Partnership might be the appropriate structure for your business. Call one of our professionals to discuss this in more detail.
Is your personal budget lower than the expected earnings from the business?
Small business corporations in Canada pay lower taxes than individuals. For example, the current small business tax rate in British Columbia is 13.5%. This compares to graduated tax rates from 20.5% to 43.7% for individuals. You can save tax by earning and retaining taxable income inside a corporation.
We all have personal budget requirements. To the extent you need to draw income out of the corporation, you are going to be faced with the personal tax rates. This is true regardless of whether you take wages or dividends from the corporation. So, if you are going to spend most of what you earn, incorporation doesn’t make a lot of sense from a tax perspective. However, you can achieve a significant tax deferral for any income you don’t need to withdraw from the corporation.
We generally like to see at least $50,000 to $100,000 per year of surplus income before recommending incorporation. At that level of surplus income, the benefits of tax deferral start to exceed the costs of creating and administering a corporation.
Do you have a low income spouse who is inactive in the business?
You would like to be able to split income with your low income spouse. Splitting income means transferring income from a high income earner to a low income earner. For example, a couple who each earn $50,000 per year will pay $6,400 less tax then a couple where one spouse earns $100,000 and the other spouse earns nothing.
An unincorporated proprietor has only one option which is to pay a wage to the low income spouse. That wage can be disallowed as a deduction by CRA if it is unreasonable in comparison to the spouse’s contribution to the business. Accordingly, splitting income with an inactive low income spouse is very risky for an unincorporated proprietor.
Some spouse’s will form a partnership to get around this issue, believing that a partnership agreement specifying a 50/50 split will get around the reasonableness test. Unfortunately, CRA has the ability to reallocate partnership income when they believe the split is unreasonable based on a similar test to the one for wages.
A solution to eliminate these risks is to create a corporation and issue dividend bearing shares to the low income spouse. The payment of dividends on these shares is an acceptable income splitting strategy that has been upheld by the Supreme Court. Many of our clients are successfully employing this strategy to split income.
There are other considerations that will affect your decision. For example, incorporating might result in a higher level of confidence in you on the part of your customers. Or you might be a non-resident wanting to structure your Canadian affairs to the best advantage.
The decision to incorporate involves a cost benefit trade-off. We encourage our clients to fully understand the costs and benefits before rushing into incorporation. Give us a call to discuss whether incorporating your business makes sense.