Our Small Business 101 series is for anyone who owns a small business and for anyone who's thinking about starting a small business. It draws from lessons we've learned while working with thousands of Canadian small business entrepreneurs over the years. It's the class we wish we'd taken before starting Origami. And the night class you should be taking right now.
Thanks to Ashley Brulotte, CPA, co-founder of Origami, and Partner at Origami Professional Corporation for his input into this post.
You're close to starting your own business, or you've already started and you're about to earn your first sale. You want to know if it's "worth it" to incorporate versus operating as a sole proprietorship. It's a great question. In this post, we'll give you the four best reasons for incorporating your small business and the main reason for not incorporating.
First, let's quickly cover the three ways you can organize as a business: sole proprietorship, partnership, and corporation:
- A sole proprietorship is a business owned by one person. It's easy and cheap to start. Apart from municipal business licenses, there are few government regulations to satisfy. Your personal income tax return will cover your income from your business. There's no need to file a separate corporate tax return. You may have to register for a GST/HST account.
- A partnership involves two or more people. It's a common way to organize for professionals like doctors and lawyers, but it's an uncommon choice otherwise. The income from a partnership is taxed as personal income to the partners. There's no need to file a separate corporate tax return.
- A corporation is a distinct legal entity with its own name and certain legal rights, like entering into contracts and acquiring and owning property. Corporations are owned by their shareholders. To incorporate, you need to prepare your articles of incorporation along with a set of bylaws. This is usually done at a corporate registry. Finally, a corporation has to obtain a business number from the CRA and file a separate corporate tax return.
Knowing your options, let's now turn to the reasons why you should consider incorporating.
1. Limited liability
One of the main benefits of incorporating a company is that it limits the liability of its owners. The shareholders of a corporation aren't personally liable should the corporation be found liable for damages in a lawsuit. In the event of legal issues or outstanding debts, shareholders' personal assets are generally protected. With sole proprietors and partners in the same situation, their personal assets are potentially at risk. Please note, however, that some debts fall outside the scope of corporate limited liability. The directors of a corporation are personally liable for any unpaid GST or employee source-deductions, regardless of the status of the corporation.
2. Tax advantages
In Canada, the small business tax rate is approximately 11% to 14% (depending on the province). This is the tax rate that you pay on "taxable income" (revenue less expenses). This rate is much lower than the rate you'd pay if you claimed the business income on your personal taxes as a sole proprietorship.
Keep in mind, as a corporate shareholder, you still will pay personal tax on funds you draw from the business for personal use; either by means of a salary or a dividend. The important point here is that a corporate shareholder is able to set their personal income by controlling the amount he or she draws from the business. This is a tax deferral opportunity that operates similarly to contributing to an RRSP, except instead of putting money into an RRSP investment account to lower your personal income, you simply don’t draw the funds from your corporation in the first place. The corporation is your RRSP!
3. Transferability of ownership
Ownership of shares in a corporation are relatively easy to transfer, with the assistance of a corporate lawyer and properly drafted legal documents of course. This gives you the ability to add future business partners and to raise additional capital by issuing new shares. Further, in Canada, we have the Lifetime Capital Gains Exemption, which establishes that the capital gains on the sale of small business shares may be exempt from personal taxes (up to $900,000). Should you grow your business and in the future choose to sell it, this is a significant tax savings opportunity (an "exit" strategy) that is not available to sole proprietors or partnerships.
4. Credibility and professionalism
For many consumers and businesses in particular, a registered corporation conveys a sense of stability and trustworthiness. Anyone can be a sole proprietor. It takes more thought, planning, and effort to set up and operate as a corporation. When you're starting out in business, that extra bit of credibility often helps and almost never hurts.
Main reason not to incorporate
It comes down to the level of income and activity in your business. If you have a full time job and this is your "side hustle" or you're just not sure if you'll be making enough to justify the costs to incorporate (and to pay a CPA to do your corporate taxes each year), then you may want to stay a sole proprietor. While every business is different, we'd say, as a rule of thumb, you probably want to be making at least $40K a year in profits (income from your business that you declare on your T1 personal tax return) before you decide to incorporate.
Keep in mind that you also have the option of registering a trade name and operating as a sole proprietor for the first year or two until your business grows. You would record your business activity on your T1 personal tax return (on the Schedule T2125) and keep things simple. Once your business starts to grow, or you need to hire your first employee, you can revisit incorporating a company.
Thanks for reading! If you're ready to start building a better business, give us a call at 1-888-745-1315 or get in touch with us by filling out our Get Started form. We're always happy to hear from you and learn about your business. We'd love to see your small business succeed, and we'd be proud to be a part of your success.