If you are the owner of a sole proprietorship, it may make sense to consider incorporating.
Let’s look at some of the issues you should think about before making your decision.
Is the business profitable? – In the first few years, a business will often generate losses due to startup costs. If you hold the business personally, the losses can be deducted against all other sources of income, assuming the business has a reasonable expectation of profit. If a business is incorporated, losses can only be applied against corporate income, not personal income.
Is the business producing more income than the proprietor needs? – If so, then incorporating may allow for income splitting, such as paying dividends to other adult family shareholders, and tax-deferral opportunities. There may be limited benefit realized by paying company profits, via salary or dividends, to the owner/manager.
Does a corporation really pay lower taxes? – Small businesses enjoy a greatly reduced tax rate (about 11 to 19 per cent, depending on the province) on the first $500,000 ($400,000 in Manitoba and Nova Scotia) of active business income due to the small business deduction. In comparison, personal tax rates can be up to 50 per cent on taxable income over about $128,000.
Is retirement or succession planning being considered? – If either avenue is being contemplated, incorporating can reduce, or defer, the taxes that would otherwise be payable. If a business qualifies as a small business corporation, a portion of any gain on the sale of the shares may be exempt from tax through the capital gains exemption.
The capital gain exemption is not available if an owner sells assets of the business. However, it is possible for a sole proprietor, anticipating a sale, to incorporate immediately before a sale and then sell the shares of the corporation to be eligible for the capital gains exemption.
You can potentially multiply the use of the capital gains exemption through the use of an estate freeze, whereby future growth of a company is transferred to other family members, but control remains with the original owner. This results in the future tax liability on the growth of the company being transferred to other family members, who in turn can make use of the capital gains exemption at a later date.
Can an incorporated business write off more expenses? – Many people believe that you can write off many more different kinds of expenses if you incorporate your business. In fact, you are still limited to writing off those expenses that were incurred to produce the income.
Other things to consider:
Limited liability – Generally, creditors of a corporation cannot seize the personal assets of the owner/manager unless he or she gave personal guarantees for loans of the corporation.
Tax holiday – In several provinces, newly incorporated business are offered up to three years of income or sales tax relief.
Non-taxable benefits – A corporation can offer benefits that are not available to sole proprietorship owners, like group health and pension plans.
Additional costs – A corporation is required to file its own tax returns and hold annual shareholder meetings, leading to higher administration, legal and accounting costs annually.
Capital tax – Some corporations are required to pay a tax on their taxable capital, although the federal government, and many provinces, are phasing out these taxes.
Kirbey Lockhart is an investment advisor with RBC Dominion Securities. This article is provided for information purposes only. Consult with a professional advisor before implementing a strategy.