When Mark started his graphic design company in Picton, Ontario, eight years ago, the legal structure of his business wasn’t top of mind. He was understandably more preoccupied with buying equipment and supplies, marketing his services, and acquiring new clients. But now that his company has grown, with three full-time employees and clients seeking him out rather than the other way around, he’s started to wonder whether he should incorporate.
Most businesses in Canada are set up in one of three ways: as a sole proprietorship, partnership or corporation.
The simplest structure, and the one Mark chose when he launched his business, is a sole proprietorship. In this case, the company and the owner are not legally distinct. Even though he operates under a registered business name and collects and remits HST, Mark pays personal taxes on all business income and is personally liable for all business risks.
If Mark had gone into business with a partner, he could have set his company up as a general partnership. It has many of the same pros and cons as a sole proprietorship – quick, easy and inexpensive to establish, but without a separate legal identity that provides protection from personal liability and the opportunity for tax savings.
The structure Mark is now considering is a corporation. It is an independent legal entity, separate from the business owner. Incorporating provides both legal and financial advantages. Legally, the business name is protected and personal liability for business risks is limited. Financially, it’s possible to transfer ownership when the time comes to sell the business and business income left inside the corporation may be taxed at a lower rate.
However, incorporating also has drawbacks that Mark will need to consider carefully. The legal and accounting costs associated with establishing and maintaining a corporation can be substantial, in part because the corporation will have to file corporate records and a separate set of tax returns every year.
When Mark sits down with his advisor, Amal, they run through the pros and cons and then Amal asks Mark three key questions that will help him decide how to proceed.
1. What risks do you and your business face?
Mark has acquired significant personal assets in the past eight years, including a home and a car, that he worries may be vulnerable if his business isn’t able to pay a business loan or, worse, declares bankruptcy. Also, while graphic design doesn’t sound especially “risky,” Mark knows of one similar company that had to pay legal fees to defend itself against an accusation it had infringed on another company’s trademark. So, being sued isn’t outside the realm of possibilities.
2. Can you leave money inside the corporation to defer taxes?
Mark’s business has net income (after expenses) of $190,000, which is significantly more than the $90,000 he needs to cover all his personal bills. As a sole proprietor, Mark has to pay tax on the full $190,000 at personal tax rates. If he incorporates and leaves $100,000 within the corporation, he’ll only pay tax on $90,000 at personal tax rates. The rest may be taxed at the lower corporate tax rate. Mark will also have greater control over when money is taxed because he can take money out of the corporation when he chooses to.
Amal emphasizes this is tax deferral, rather than tax elimination, because the money will generally be subject to personal tax rates at some point if Mark withdraws it from the corporation. However, in the meantime, he can use the money he’s saved on taxes to invest in his business’s growth.
3. What is your succession plan?
At age 40, Mark is still a long way from retirement. Nevertheless, Amal encourages him to think about what will happen to his business when he’s ready to stop working. As an owner of a small incorporated business Mark may be able to benefit from a lifetime capital gains exemption if Mark sells his shares to a successor. Also, a corporation lives on after its owner’s death, which means that it can be integrated into Mark’s estate plan, with its value transferring to his beneficiaries on death.
Get professional advice before deciding
Choosing the structure of a business is a foundational decision that has a significant impact on legal liability, taxation, succession planning and estate planning. That’s why Amal tells Mark it’s essential to build on their conversation with specialized legal and tax guidance. That said, Mark is now more informed and in a better position to make the right choice for his personal situation.
Does incorporation make sense for you?
Incorporating may be a good idea if …
Incorporating may not work for you if …
|You want to protect personal assets by limiting personal liability to business creditors.||You’ve addressed risk from business creditors in other ways, such as through errors and omissions insurance.|
|You can leave money inside the corporation to take advantage of tax deferral.||You need all your business’s income to pay your living expenses.|
|You hope to sell your business one day and benefit from the lifetime capital gains exemption.||You are your business, meaning it has little or no value beyond your contributions to it.|
|You’re growing your business, so can accept that corporate losses can’t be applied against personal income – only against future corporate income.||You’re still getting your business off the ground and operating at a loss, so you want flexibility to apply business losses against your personal income.|