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Is Incorporating Your Business the Right Choice? Weighing the Pros and Cons
By Wajahat Ajmal
Is Incorporating Your Business in Canada the Right Move? Discover the Pros and Cons with Examples and a Simple Decision-Making Framework.
Table of Contents
This article will guide you through the advantages and disadvantages of incorporating your business in Canada.
It will also provide examples of when incorporation could be beneficial and when it might be best to reconsider.
Advantages of Incorporating
Let’s begin by outlining the benefits of incorporating your small business, followed by a detailed explanation of each.
- Limited Liability – Incorporating your business shields your personal assets, making it harder for creditors to pursue them if the business faces financial difficulties.
- Tax Savings and Deferral – Corporations can sometimes benefit from lower tax rates than individuals. Running your business through a corporation rather than a sole proprietorship may help in deferring and reducing taxes.
- Income Splitting – While income splitting was once a major reason for incorporating, changes in tax regulations since 2018 have reduced its advantages. It can still be beneficial but is less impactful than before.
- Lifetime Capital Gains Exemption (LCGE) – Certain incorporated businesses can sell at a profit of up to $1.25 million (as at 2024) without being taxed, thanks to the LCGE.
- Estate Planning – Since a corporation exists as a separate legal entity, it continues to operate even after your death, which can be advantageous when transferring assets to beneficiaries.
Limited Liability
When running a business, there’s always a chance it could face losses or accumulate debts that can’t be paid.
If your business is structured as a proprietorship, your personal assets, such as your house and car, could be used to settle the business’s debts.
However, if you’re operating through a corporation, your liability is limited to the assets within the company. Your personal assets typically remain protected if the business can’t cover its debts.
For instance, if a plumber performs faulty work that leads to a flood, the customer could sue for damages.
If the plumber operates as a sole proprietor, the customer could pursue the plumber’s personal assets to cover the damages. But if the business is a corporation, only the assets within the company would be at risk.
Tax Savings and Deferral
Corporate tax rates for small businesses in Canada are often much lower than personal tax rates, offering the potential to save or defer taxes when operating through a corporation.
There are various factors to consider when evaluating the tax impact of incorporation. A corporation provides more flexibility in how and when income is earned, potentially leading to less tax owed.
For example, Max runs a plumbing business that net profit of $300,000 annually, but he only needs $70,000 to maintain his lifestyle.
If he operates as a sole proprietor, he would pay personal taxes on the full $300,000 in the same year, resulting in about $123,000 in taxes.
By incorporating, he could choose to withdraw only $90,000 from the corporation in a year, which would reduce her total tax bill to around $48,000 ($37,000 corporate tax and $11,000 personal tax).
The $129,000 in tax savings could stay within the corporation and be reinvested in the business.
However, this tax isn’t permanently avoided—it’s merely deferred. When Max eventually withdraws that money from the corporation, he’ll still need to pay personal taxes on it.
If he instead reinvests the money into income-generating assets within the corporation (like buying power tools or other assets), he wouldn’t have to pay personal taxes on those funds.
The true advantage lies in using deferred tax savings to grow the business and being able to plan personal income to benefit from lower marginal tax rates.
Income Splitting
Prior to 2018, income splitting was a popular reason for incorporating a business. Business owners could pay dividends to a lower-income spouse, who would then be taxed at a lower rate.
However, as of January 1, 2018, new rules known as the tax on split income (TOSI) have greatly restricted the use of this strategy. These regulations are designed to reduce the advantages of income splitting through private corporations.
TOSI rules apply if the recipient of the income is an adult family member who hasn’t contributed enough to the business. The standard for “sufficient contribution” is working an average of 20 hours per week in the business.
The key point is that dividends paid to adult family members who are not actively involved in the business are taxed at a higher rate. As a result, the benefit of income splitting through incorporation has been significantly diminished. Read about TOSI in relation to Dividends paid here.
Lifetime Capital Gains Exemption (LCGE)
The Lifetime Capital Gains Exemption allows owners of Canadian Controlled Private Corporations (most small businesses in Canada) to enjoy tax-free capital gains of up to $1.25 million as of 2024 (The limit increases every year mostly).
Here’s an example to show how beneficial this exemption can be.
Abdur runs a trucking business that he built from scratch, which now generates $900,000 in annual revenue. As he approaches retirement, Abdur finds a buyer willing to purchase the business for $900,000.
Since Abdur started the business from zero, its original cost was $0, meaning the $900,000 is entirely capital gain.
If Abdur had been operating as a sole proprietor, the $900,000 gain would be taxable, and he would owe around $150,000 in Capital Gain taxes.
However, because Abdur operates through a corporation, he qualifies for the LCGE, making the full $900,000 gain tax-free. He would pay $0 in Capital Gain taxes!
There are specific requirements to meet before claiming the LCGE on a business sale.
Estate Planning for Corporations
In the realm of Canadian business law, corporations possess a unique legal status that sets them apart from other business structures. As distinct legal entities, corporations enjoy rights and responsibilities akin to those of natural persons, including the ability to own assets, secure loans, and enter into contractual agreements.One of the key advantages of corporate structures is their continuity beyond the life of the business owner. Unlike partnerships or sole proprietorships, which dissolve upon the owner’s death, corporations persist, with ownership transferring to the shareholder’s heirs. This inherent stability offers several benefits:
Long-term Planning
The enduring nature of corporations facilitates extended strategic planning, allowing business owners to develop and implement long-range goals with greater confidence.
Asset Transfer Flexibility
Corporate structures provide enhanced flexibility in transferring assets, making them particularly advantageous for estate planning purposes.
Generational Business Transfer
For entrepreneurs aiming to create a lasting legacy and pass their business to future generations, the corporate model often emerges as the optimal choice. Its structure inherently supports smooth ownership transitions, ensuring business continuity across generations.
In summary, the corporate structure’s ability to outlive its founders, coupled with its flexibility in asset management and transfer, makes it a compelling option for those focused on long-term business planning and generational wealth transfer.
Drawbacks of Incorporating a Business in Canada
Incorporating a business in Canada offers numerous benefits, but it’s crucial to consider the potential drawbacks as well. Here are some key disadvantages of incorporating a business in Canada. Lets discuss the disadvantages, each one discussed in detail below:
- Initial and Ongoing Costs – Initial setup costs can be high
- Administrative Burden – It increases administrative burden as additional legal requirements are to be fulfilled.
- Complex Tax Implications – The taxation requirements are sometimes complex and can result in double-taxation if not thought through in some scenarios.
- Increased Regulatory Requirements – The regulatory requirements are increased and usually risk of being fined or facing adverse consequences if they are not met.
Initial and Ongoing Costs
Incorporating a business involves significant upfront expenses and ongoing financial commitments:
Setup Costs: The initial incorporation process can be costly, requiring government fees, legal fees, and potentially accounting fees. For example, the government fee for incorporation is $300 CAD in Ontario and $350 CAD in British Columbia.
Maintenance Expenses: Corporations face ongoing costs for annual filings, maintaining proper records, and complying with government regulations. These may include legal and accounting fees for annual filings and maintaining a minute book.
Administrative Burden
Incorporating a business leads to increased administrative responsibilities:
Compliance Requirements: Corporations must fulfill various ongoing obligations, such as filing annual corporate tax returns, maintaining detailed records, and adhering to government regulations.
Time and Resource Allocation: The increased administrative workload may necessitate additional time and resources, potentially requiring the hiring of an accountant or investment in accounting software.
Complex Tax Implications
While incorporation can offer tax benefits, it also presents some tax-related challenges:
Difficulty Using Losses: Unlike sole proprietorships or partnerships, corporations may face limitations on utilizing business losses to reduce future taxes. Losses can only be carried forward or backward within certain restrictions, potentially limiting their immediate tax benefits.
Potential for Higher Taxes: In some scenarios, operating as a corporation could result in paying more taxes compared to other business structures.
Double Taxation: Corporations are subject to taxation on their income, and shareholders are taxed again when receiving dividends, potentially leading to double taxation.
Increased Regulation and Complexity
Incorporating a business brings additional regulatory and operational complexities:
Regulatory Compliance: Incorporated businesses are subject to more regulations than sole proprietorships or partnerships. This includes maintaining corporate records, filing annual reports, holding shareholder meetings, and complying with securities regulations.
Limited Control: Shareholders of a corporation may have restricted control over the day-to-day operations of the business.
Complexity: The incorporation process and ongoing management can be complex, often requiring professional legal or accounting assistance. In conclusion, while incorporation offers many advantages, it’s essential to carefully weigh these disadvantages against the potential benefits when deciding whether to incorporate your business in Canada. Consider factors such as your business size, long-term goals, and financial situation to determine if incorporation is the right choice for your specific circumstances.
Now Should I Incorporate My Business?
After reviewing the pros and cons of incorporating, you may still wonder if it’s the right decision for your business. Many people assume that incorporation is the gold standard, but this isn’t always true. There are specific instances where incorporation makes sense, and other times when operating as a proprietorship is more beneficial. To clarify, we’ll explore examples and provide recommendations for each scenario. Keep in mind, these examples are simplified to explain the general concepts, so it’s always a good idea to consult with an accountant or lawyer before making a decision.
Concerned About Liability – Incorporation Can Help
Liability is a common reason for incorporating small businesses in Canada. If the business incurs debts, incorporation protects personal assets, limiting risk to only the company’s assets. Incorporation can save the owner from personal financial ruin. However, there are cases where directors of incorporated businesses can still be held personally liable, such as unpaid employee wages, payroll remittances, and unremitted GST/HST. Additionally, banks often require personal guarantees for early-stage corporate businesses, making the shareholders personally liable for debts.
Summary: Liability concerns can make incorporation the right choice, but discussing this with a lawyer is advisable.
Building a Business to Sell – Incorporation Can Help
If your goal is to eventually sell your business, incorporation can provide significant tax savings. By operating through a Canadian Controlled Private Corporation (CCPC), you may qualify for the Lifetime Capital Gains Exemption (LCGE), allowing you to sell your shares tax-free up to $1.25 million as at 2024. To qualify, 90% of the company’s assets must be used in active business at the time of sale, and at least 50% of assets must be actively used for 24 months prior. Additionally, the owner must have held the shares for at least 24 months.
Summary: Incorporation can drastically reduce taxes when selling a business.
Business Earns More Than You Need – Incorporation Can Help
Incorporation is beneficial when your business earns more than what you need for living expenses. Extra earnings can remain in the corporation, taxed at a lower corporate rate instead of higher personal tax rates. The deferred tax is only paid when the money is distributed to shareholders as wages or dividends.
Summary: If your business generates more income than needed for living expenses, incorporation can help defer and potentially save on taxes.
You Are Your Business – Incorporation May Not Help
In some cases, the owner is the entire business, with little reason to incorporate. For instance, Bob the Bathtub Baron runs a solo bathtub repair service with no plans to sell or pass the business to his family. His business operates in a low-risk industry and earns enough for his living expenses and retirement. Incorporation in such cases may only lead to higher costs and more administrative duties without significant benefit.
Summary: Owner-operated businesses may not see much advantage from incorporation, and the downsides could outweigh the benefits.
Expecting Losses – Incorporation May Not Help
Start-up businesses often incur losses in their early years. If operating as a sole proprietorship, those losses can be applied against other personal income, reducing taxes. In a corporation, losses can only be applied against future corporate income. Thus, a proprietorship offers more immediate tax benefits in loss-making years, with the option to incorporate later once profits begin.
Summary: If a business expects losses initially, it may be better to avoid or delay incorporation.
Real Estate Rental Businesses – Incorporation May Not Help
Real estate rental businesses often ask about the tax advantages of incorporating. However, unless the business is large (employing more than five full-time employees), rental income is classified as investment income and taxed at a higher rate. In many cases, it’s easier to own property personally, as personal ownership makes mortgages simpler to obtain, and you may qualify for a principal residence exemption to reduce capital gains tax.
Summary: For smaller real estate rental businesses, personal ownership may be a better option, as corporate tax benefits are limited.
Conclusion
In conclusion, deciding to incorporate or not depends on several factors as listed. It is always advisable to work with a professional to determine if it is the right choice for you or not.
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