One of the most frequently asked questions I get is “Should I incorporate?” Many small businesses are growing fast, and have heard from friends, colleagues, or the internet that they should incorporate their business. The advice below is general in nature but is more tailored for Canadian businesses.
What is incorporation?
The process of incorporating means to form a separate legal entity from yourself. This corporation will be responsible for filing its own taxes. It will have to have a bank account, and you will have to keep separate, often more complex accounting records.
Should you incorporate?
The way I see it, there are three reasons why somebody would want to incorporate. Is your business one that’s likely to get sued for a lot of money? Are you looking to sell your business at some point in the future? Do you have enough retained earnings to save tax by incorporating?
1: Are you at risk of being sued?
If the type of business you’re in has a high risk of being sued or you are at risk of liability, you may want to consider incorporating.
If the worst case scenario with an unhappy clients is that you refund their fees, this usually isn’t a big risk.
For example, an owner-managed graphic designer may end up with an unhappy client who doesn’t pay, or demands a refund, but the chance of being sued for a large amount of money is low.
Conversely, if you run a fitness facility for kids and one of those kids gets injured, you can bet that the parents would be looking to sue for more than just a refund of their course fees.
If someone gets injured at your workplace or property is damaged because of your actions (or those of your staff), they can sue. If you’re incorporated, they can usually only go after the assets of the business. If you’re not incorporated they can also go after your personal assets including your home and your car.
2: Are you looking to sell your business?
It’s easier to sell a business if it can be shown as an independent entity. There are also tax benefits to selling off a business that is incorporated. Some businesses are just not sellable, such as a sole proprietor who is in effect, the business. In that case, it may not be helpful.
However, if you manufacture widgets, someone could buy the business from you and continue to run the business without you.
There are also significant potential tax savings (the Lifetime Capital Gains Exemption) to selling the shares of some corporations. If this would apply, this is definitely worth having a discussion with an accountant to make sure your business will qualify.
3: Are you looking to pay less tax?
This is the issue that trips up a lot of people. Is anyone looking to pay more tax?
The tax rate that corporations pay is significantly lower than individuals. Personally, people can pay up to 53.53% (2016, Ontario) of their income in tax. A small corporation in Ontario generally pays a flat 15% on the income.
Where you’ll actually save on taxes is if there’s money at the end of your year that’s just sitting around. This money that’s just sitting around can be left inside the corporation. In that case, the corporation pays tax on it, but you don’t.
Let’s look at an example of this. Say you end the year with $20,000 that you aren’t using to grow the business further, and you didn’t spend personally. For this example, let’s assume your personal marginal tax rate (the rate you’ll pay on additional income on top of what you’ve already got) is 40%, and the corporation’s rate is 15%.
If this money was added to your personal income because you didn’t have a corporation, you’d pay $8,000 in tax on that income. If you leave that money in the corporation for the future, you will pay $3,100 in tax this year on that income. Leaving the money in the corporation has deferred $4,900 of tax, and depending on your situation going forward may significantly reduce the overall tax you pay.
Alternatively, if you have a spouse who doesn’t work, or adult children, and are looking to divide the income of the business, this can be done by making them shareholders of the company and paying dividends to them. This has the benefit of not needing the individual to actually work for the company (which is required if you are paying a salary to that person). This can afford significant tax savings for parents with kids in university, or situations where only one spouse works.
Another scenario in which it may make sense to incorporate is if you have income that is acyclical. For instance, let’s say you close a large deal worth $400,000 that you don’t expect to repeat. If you take that money as a self-employed person, you’ll pay the highest possible rates on some of that income, even if you plan to live on it for years. If it’s paid to the corporation and slowly paid to you over time the total tax paid is significantly lower.
Between the cost of setting up the corporation, administration, bank fees and accounting that has to be done, you have to be saving sufficient money in the corporation each year before you actually end up saving money, and not just paying less tax. The general advice we give is that you should have annual profit you’re not using in the business or personally of at least $20,000 before you will save money by incorporating.
If you would like to discuss your personal situation to figure out whether incorporation is right for you, please get in touch.
Ian Edmonds is a CPA, CA and CPA (NC) working in Toronto with small and medium-sized businesses, individuals, and not-for-profit organizations in Canada and the US to provide personalized, approachable tax and accounting advice and services and help people avoid expensive tax situations.