To incorporate or not, that is the question—at least for many small businesses that earn above $60,000 annually. This is because, once you exceed the $60,000 mark, the lower tax rate of a corporation becomes much more appealing than the personal marginal rate. That said, there is much more to incorporation than lower taxes, and a lot more to think about.
When you incorporate a sole proprietorship or partnership, your business is no longer just you—it’s an entity unto itself. Under Canadian law, corporations have the same rights and obligations as people: they can accumulate assets, earn revenues, go into debt, be sued and even enter into contracts. The assets the corporation accumulates belong to the corporation, not to the shareholders personally.
Corporations also have significantly more complex structures than other types of businesses. For instance, activities must be carried out by shareholders, directors and officers. Similarly, there are more stringent requirements around record-keeping and the filing of annual returns.
Despite the complexities, incorporating your business—either at the onset or later in its lifecycle—can often be a smart move. Consider these benefits:
The lower tax rate afforded to corporations, thanks to the small business deduction, can greatly assist your financial planning efforts—provided you are in a situation where your personal cash needs are less than your earnings potential. In this situation, you can leave money in the corporation where it will be taxed at the lower corporate rate—so you’ll have more after-tax money to invest in the corporation, save for retirement (when it will be withdrawn at a lower tax rate) or fund a sabbatical, maternity/paternity leave or extended period of time off.
By making your lower-earning spouse or children shareholders in the corporation (something that’s permitted in most provinces), you can split your income with them by paying them corporate dividends—which will then be taxed at their lower personal tax rate. Keep in mind, however, that while your children can be shareholders at any age, they must be over 18 to receive dividends.
If you don’t wish to put shares directly into their hands, you can create a family trust of which your child or children would be the beneficiaries, letting you allocate discretionary funds to them each year as required to maximize your income splitting opportunities.
Paying a salary to your spouse or children from the corporation is another possible income splitting strategy, but the salary must be “reasonable.” By “reasonable,” the amount must be equivalent to what you would pay a third party for the same level of work. Dividends, on the other hand, do not need to meet the definition of reasonable, as dividends are a form of investment income.
Shareholder liability is limited as part of a corporation—so creditors cannot sue shareholders individually for debts incurred by the corporation. That said, directors can—in certain circumstances—be held personally liable (e.g., if the company fails to pay employee wages or remit its taxes). For this reason, you may want to consider creating a separate holding company where you can invest excess funds not required for personal spending to protect them from your corporation’s creditors, as well as increase your insurance protection. While prudent, these steps will obviously escalate your administrative costs and the complexity of your corporate structure.
Incorporation is a big step—one that can change the nature of your business and have long-term implications for you and your family. While many of these implications can be advantageous, it’s wise to take some time to consider your personal position—as well as the pros and cons of incorporation—to determine if such a move is right for you.