By Christina Potter, CA
Sole proprietors or partners in a partnership who are considering incorporating often ask the question "At what income or profit level does it make financial sense to incur the costs of incorporating?"
The incorporation of a sole proprietorship has significant legal and financial implications. Unlike sole proprietorships, a corporation is a legal entity completely separate from its shareholders. The shareholders' liability for the debts and obligations of the business is limited to what they put into the corporation and anything they guarantee on behalf of it. Limited liability is one of the main reasons why many sole proprietors incorporate.
The other main reason for incorporation is to take advantage of the tax benefits available to active businesses eligible for the small business deduction. Eligible corporations pay tax at a rate of about 16 per cent on the first $500,000, compared to personal rates in excess of 48 per cent in the top marginal bracket.
A tax deferral is possible to the extent that earnings are retained in the corporation, as these earnings will be taxed at the lower rate of tax. The shareholder pays the remaining tax when the earnings are paid out as dividends or a salary. You can control the amount and timing of personal income you receive from the business. The payment method will determine your personal and your corporation's tax liability, as well as your contribution limits to CPP and RRSPs.
Currently, there is a slight advantage to receiving dividends as opposed to salary. However, dividends are not considered earned income and therefore are not included in determining your RRSP contribution room.
The tax system is designed to be neutral between income earned personally or through a corporation. As a result, the benefit of tax deferral is lost if you are currently withdrawing all the funds from the business for personal use. On the other hand, if your business profits are in excess of your personal requirements, you may want to consider incorporation.
Generally, it does not make sense from a tax point of view to incorporate an unprofitable business. Sole proprietors can use business losses to offset other sources of income or even recover personal taxes paid in previous years.
Conversely, if you incorporate, the losses stay in the company where they can only be used to offset future earnings in that corporation. If the business fails then the tax benefit of the losses is lost.
A permanent tax advantage of incorporation is the $750,000 capital gains exemption available on the sale of your shares, providing that your corporation is a qualified small business corporation and meets specific criteria.
The transfer of a sole proprietorship to a corporation is normally a taxable event unless a rollover agreement is made and the appropriate election is filed with Canada Revenue Agency. This allows the transfer to take place on a tax-deferred basis.
Other advantages of incorporation include: perpetual existence, increased ability to raise capital and greater flexibility in estate planning.
One of the major disadvantages of incorporation is the increased costs and administration. Incorporation fees can range from $500 to $1,500, depending on whether you do it yourself or use a lawyer. Incorporation also involves extra legal and accounting costs.
Clearly, no one method of carrying on a business is superior in every case. You should seek the assistance of your professional advisor to help you make this decision.
