So you've started your own small business, and business is good. Your starting to gain more customers, cash flow is positive, and revenues are exceeding expenses. What is the next step? Some believe that this is the best time to incorporate your business, and there may well be good reason to do so. But is this an automatic decision? What are the pros and cons of incorporating your business operations? This article will examine these and other issues on a basic level. After reading and understanding what the issues are, you will be ready to speak with your financial advisors regarding your specific situation. Most businesses are unique in some way, and incorporation is not for everyone. Beware of false or misleading information from friends, co-workers, associates or others who have supposedly benefitted from incorporation.
In general, there are two main reasons to incorporate, from which flow many pros and cons. First, there is a more favourable income tax rate for profits of a small, incorporated business, and an opportunity for income tax deferral with some careful tax planning. Second, there is legal liability protection from creditors when your business is operated from within a "corporate shell".
RULE #1Your company must generate a profit in excess of your expenses and your salary before you can take advantage of the lower tax rate for small incorporated businesses.
Profits of a small business are taxed at a lower combined federal/provincial rate than those of an unincorporated business. As a small business owner, you know that your unincorporated profits are taxed, through your personal income tax return, at your marginal rate of tax. In the Province of Ontario, that could be as high as 51.6%. For incorporated companies, the combined rate of tax in Ontario is 22.84% on profits up to $200,000. On profits over $200,000, the rate jumps to 43.00%. It looks very attractive to incorporate your company based on these facts. However, this is only a generality. The following three additional Rules must be adhered to to benefit from this advantage.
There is one common pitfall of incorporation from an income tax standpoint.
RULE #2In order to enjoy the low rate of tax, there must be profit to tax.
Let's look at a typical example from our day-to-day practice. Mr. Jones runs a small consulting business from his home, and makes a good living, one that is very comparable to his days working for a large firm. He has decided to incorporate because he has heard that incorporated companies in Ontario only pay 22.84% income tax, and this is much less than what he pays personally. His unincorporated profit and loss statement is as follows:
REVENUE $200,000
EXPENSE $100,000
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NET INCOME $100,000
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Therefore, Mr. Jones pays tax at his personal marginal rate of, for example, 51.6%. Incorporation is looking better all the time. But is it? Mr. Jones' family lives a lifestyle that requires him to use his after-tax profit to live on. It is his salary in effect. If he was to incorporate his business, he would have to draw all the profit from the company as a salary in order to live. His incorporated profit and loss statement would now look like this:
REVENUE $200,000
EXPENSE $100,000
SALARY $100,000
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NET INCOME $ 0
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His net profit would be zero, and therefore, the company would pay no income tax. However, Mr. Jones pays tax at his personal marginal rate of 51.6% on the salary he withdrew. Is there an advantage? Obviously, in this limited scenario, there is no advantage to incorporating his company.
RULE #3One must plan the time of incorporation to ensure that losses are properly utilized.
The opposite of the above scenario is more common. That is, your are more likely to generate losses in the first few years of operation. As a sole-proprietor, these losses can be written off against all other sources of income on your personal income tax return. If the losses exceed all other income, then you may carry the net loss back three years, or forward seven years, to offset prior or future years' income.
If you incorporate however, these losses are the property of the incorporated company, since it pays its own income taxes. The losses can be carried back or forward as above, but they cannot be utilized by you personally. Therefore, the timing of incorporation can be critical.
RULE #4Incorporate only when you pay more tax on retained profits than an incorporated company would.
When strictly speaking from an income tax planning viewpoint, you should incorporate when your sole proprietorship reaches a level of consistent profit which, when taxed at your marginal rate, equals or is higher than the small business rate of an incorporated company. Put more simply, at what level of profit do you pay the same rate of tax as a company? When you reach that level consistently, incorporate.
In the Province of Ontario, based on 1997 tax rates, an individual will pay the same rate of tax as an incorporated small business at approximately $34,000 per annum. This assumes a single taxpayer with a basic personal exemption and CPP credit. If your profit is consistently less than this threshold, then the advantage of a lower tax rate is not gained.
There are other issues to consider that will impact your decision, including income splitting, deferred management bonuses, the capital gain exemption election on selling your business, and allowable business investment losses if your business should fail. For further information, please email us.
When you operate your business from within an incorporated company, you generally enjoy limited liability protection from your creditors. If your business should fail, creditors can generally attack only the assets of the incorporated company. Your personal assets are not exposed. However, of most importance, you are fully responsible for any unpaid payroll deductions and/or GST unpaid by the incorporated company.
While limited liability protection is a big advantage of incorporating, perhaps as a sole proprietor you could protect yourself against alot of the same risk by properly insuring the operations of the business?
Finally, if you are preparing to borros money from your banker for your incorporated business, prepare to sign a personal guarantee for the debt. Banks are not willing to take any risk by being grouped with the general creditors.
In summary, legal liability protection is a big advantage of incorporation. However, depending on your particular circumstance, you may end up in the same legal position as being unincorporated.
There are other issues to consider including employee benefits, pensions plans and possible reductions in probate fees on your death of you were to transfer some of your assets to an incorporated company. These issues are beyond the scope of this article.
Since an incorporated company is a seperate legal entity from its owners, it files its own tax returns and prepares its own financial statements. This means increased paperwork and recordkeeping. This leads to increased fees for accountants and lawyers as the time to prepare these documents increases.
This article has touched on only a few of the many variables you need to consider when deciding to incorporate your small business. There is a common misconception that incorporation somehow legitimizes your business venture and opens the door to new types of deductions. This could not be farther from the truth. The best piece of advice we give our clients is that if you are entitled to deductions, whether you are an employee, self-employed, or incorporated, you will receive those deductions.
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