Many business owners have the same question at one point in their careers – when do I incorporate? It is not as simple as “when you see profits” although we wish the decision was that easy. For-profit businesses can be structured in one of three ways:
- Sole proprietor
- Partnership
- Corporation
To start, lets discuss the benefits of forming a Canadian-controlled private corporation (CCPC):
Limited personal liability – The corporation is a legal entity, separate from you and your potential business partners (and families). This means your personal assets are protected against most* creditors or if legal action is taken against the business.
* Talk to an accounting or tax professional for exceptions.
Preferred tax rates – Federal tax rates are typically 15% of all active income earned, plus a provincial tax on all income earned in each province (tax rate varies by province). The CCPC has the benefit of the small business deduction which reduces the corporate tax rate on the first $500,000 of active business income*. Income beyond the first $500,000 is not eligible for the small business deduction. Federally, the small business deduction reduces the tax rate from 15% to 9%. Provinces and territories also provide their own small business deduction, providing further tax reductions. Here in Manitoba, the small business deduction reduces the tax rate from 12% to 0%.
* Talk to an accounting or tax professional for exceptions.
Income tax deferral – When you take cash or assets out of the corporation, the person taking the cash or asset must pay tax at their individual tax rate at that time. That tax rate is frequently at a higher rate than the corporation is going to pay. Therefore, if you do not need to withdraw all the income that your business earns, you can leave the surplus of cash in the corporation until it is required. This surplus profit will be taxed at the CCPC tax rate and remain in the corporation until withdrawn, resulting in the deferral in personal tax rates on the surplus profits over time.
Lifetime capital gains exemption (LCGE) – when you sell a company, you would typically pay taxes at the capital gains tax rates on the entire gain. By selling a CCPC, you are selling the entire corporation in one transaction (ie. You sell your share capital). If you see profits on the sale of a CCPC, your tax rate is reduced to 0% on the first $971,190 of gains (up from $913,630 in 2022). Keep in mind, you may be charged alternative minimum tax (AMT) on the sale, even if you qualify for the LCGE. AMT is a tax charged in the year of disposal of the CCPC and is refundable over the following seven years if you continue to earn income in Canada.
Now, let’s review some downsides to incorporation. To be honest there aren’t many!
Cost – The cost to incorporate consists of legal and accounting support. This costs money. Plus, the annual costs to maintain your corporation and file the corporate tax return costs more than a business filed as part of your personal tax return.
Bookkeeping – The corporation is a separate legal entity therefore all income the corporation earns must be deposited into the corporate bank account and tracked and all money taken out of the corporation must also be tracked. Separate bank accounts must be maintained, and monthly bank reconciliations are a key step in ensuring appropriate tracking of all cash flows. You must think of the company’s cash flows and assets as being owned by a separate entity from yourself.
Administrative responsibility – There is an increased burden on the owners of a corporation to maintain appropriate books and records. In addition to the bookkeeping responsibility, the CRA expects corporations to maintain a separate bank account, loans, and credit cards. All invoices must also be produced in the corporation’s name (where possible) and paid by company resources wherever possible.
Finally, we will discuss some factors that come into play when discussing if incorporation is right for you:
Personal tax situation and company profits
- You want to ensure the tax deferral potential on your corporate profits will outweigh the personal taxes you would otherwise pay if you were not incorporated. Consider the pros and cons above and determine if incorporating will provide tax savings greater than the cost of owing a corporation, and if incorporating will be “worth the administrative burden” placed on you.
- Consider if you can contribute to RRSPs to equally reduce your taxable income, which may postpone the financial benefits to incorporation.
Goals
- Are you at a retirement phase? Should you incorporate so you can sell using your LCGE? Consider if the LCGE will provide tax relief greater than the legal and accounting costs to incorporate.
- Are you wanting more growth which will ultimately mean more profits and inevitable incorporation?
Your personal budget
- If your personal budget shows that you are using all company profits in day-to-day living, debt repayments or other expenses, this is an indication that there may be little to no income remaining in the corporation to benefit from the tax deferrals available.
Legal liability
- Some companies would benefit from the limited liability benefits that come with a corporation. If you operate in an industry that has a high risk of legal action being taken against your business, you may want to consider incorporating to provide both peace of mind over your personal assets, and possibly reduced liability insurance requirements.
As you can see, the decision to incorporate is not always as simple as it seems. It should be discussed with your accounting or tax professional to ensure you make a decision that truly benefits you and your business.
If you would like to know more, please contact our office for trusted advice and personal service.