To Incorporate or Not

Usually, business owners begin their businesses as sole proprietors or partnerships. Then, after a few years of being in business they ask themselves whether or not they should incorporate.

The decision is not a simple one since they need to take their current and future business and personal goals into consideration. To help them make this decision, I strongly recommend that they consult either an accountant or lawyer. When my car needs some TLC, I see my mechanic. If I tried to repair it myself, I would end up walking or riding my bike to work, which wouldn’t be a bad thing for my health or the environment.

My goal for this month’s column is to introduce the general concepts of incorporation. I will begin by briefly explaining the three types of business structures for the non-businesses owners reading this article.

A sole proprietor is a person operating an unincorporated business. The business is not a separate legal entity from the owner. The owner is the business. A partnership is very similar, the only difference being that there are two or more persons involved in the operation of the business. They both report their business income or losses on their personal income tax returns, also known as a T1. The corporation is an incorporated company and a separate legal entity from the owner; it reports its business income or loss on a corporate income tax return, also know as a T2.

Generally, a business owner will consider incorporating when the business becomes profitable, this usually happens three to five years after the business was started. Why? The profits (income) of corporations are taxed at a lower rate than individuals. Therefore, by incorporating you can reduce the amount of tax you need to pay.

One of the other advantages is limited liability. If a corporation experiences financial difficulties, the owner’s personal assets, residence for example, are protected against lawsuits from creditors. The personal assets of a sole proprietor or partnership are not protected. However, owners of corporations are not protected from every creditor. The Canada Revenue Agency will ensure that any monies owed from GST/HST, payroll taxes and income tax will be paid. Also, banks always require business owners, incorporated or not, to personally guarantee bank loans. So incorporating does not give you a “get-out-of-jail-free” card.

The main disadvantage of incorporating is the costs. The set-up fees of a corporation are more expensive than the ones of a sole proprietor or partnership. Since its administration can be more complex, the accounting and legal fees will be higher. The tax savings that result from the incorporation usually offsets these.

In addition a corporation can reduce the taxes it pays, by using tax deferral methods or income splitting with family members. These options are also available to sole proprietors or partnerships. That being said, incorporation may not be the answer for you and your business. By having an accountant prepare your tax return throughout the life of your business, they will able to recommend what the best course of action is for your situation.

The advantage of being sole proprietor and partnership is that business losses can be applied against any other personal income and that reduces the amount of taxes you are required to pay. Losses from corporations cannot be applied against the personal income of its owners; it can only be applied against business income.

If you are considering incorporating do your research and consult. The Internet is a great source of information and of course your accountant and lawyer will be able to provide assistance when you are ready to make the decision.