To incorporate or not - that is the question

Countless new businesses are started each and every year in Canada and the same question nags at these new entrepreneurs – should I incorporate the business or leave it setup as a sole proprietorship or partnership?

Let’s take a look at the basics of each structure and the pros and cons of each.

A sole proprietorship is the simplest form of business ownership. The business is not a separate legal entity, meaning all profits and losses are directly passed to the owner, who reports them on their personal income tax return. This structure offers minimal administrative burden and allows the owner full control over the business.

In a partnership, two or more individuals share ownership and responsibilities. Like sole proprietorships, the income earned by the business is reported on the personal tax returns of each partner. Partnerships allow for shared decision-making and can bring complementary skills and resources to the business.

Pros of sole proprietorships and partnerships

1. Simplicity: Setting up and operating a sole proprietorship or partnership is straightforward, with fewer regulatory requirements and lower administrative costs.

2. Direct taxation: Owners or partners report income on their personal tax returns, which can be advantageous if the business is earning modest profits, as they can benefit from lower personal income tax brackets.

3. Full control: In a sole proprietorship, the owner has complete control over all business decisions, while in a partnership, decisions are made collaboratively among partners.

Cons of sole proprietorships and partnerships

1. Unlimited liability: Owners are personally liable for all business debts and legal obligations. This can put personal assets, such as homes and savings, at risk if the business faces financial difficulties or lawsuits.

2. Higher tax rates: As income increases, the personal tax rate can be significantly higher than the corporate tax rate, resulting in a larger portion of profits going to taxes.

3. Limited growth potential: Sole proprietorships and partnerships may struggle to attract investors, as these structures are seen as less formal and stable than corporations.

Incorporating a business creates a separate legal entity, meaning the business itself is responsible for its debts and obligations. This provides personal protection for the owner’s assets and can offer more tax planning opportunities.

Pros of incorporation

1. Limited liability: One of the most significant advantages of incorporating is the protection it provides to personal assets. In the event of business failure or lawsuits, the owner’s personal assets are generally protected from creditors.

2. Lower corporate Tax Rate: Small businesses in Canada benefit from a federal tax rate of just nine per cent on the first $500,000 of active business income, which is substantially lower than personal tax rates. This can be particularly beneficial for businesses that generate significant income and allow profits to accumulate within the corporation.

3. Tax deferral: Owners of incorporated businesses can choose to leave profits in the corporation, deferring personal taxation until they withdraw the funds as dividends or salary. This can allow for greater control over income and tax planning.

4. Access to investment: Corporations are often more attractive to investors, as they can issue shares and are seen as more stable. This structure can help businesses grow and secure funding more easily.

Cons of incorporation

1. Increased Administrative Burden: Incorporation comes with higher administrative costs, including legal fees, accounting costs, and the need to maintain corporate records. Annual filings and financial statements add to the complexity.

2. Double taxation: While corporate profits are taxed at a lower rate, withdrawing income from the corporation results in a second layer of tax. Dividends and salary are both subject to personal taxation, meaning business owners need to carefully manage how and when they take income.

3. Less flexibility: Corporations are subject to more regulations and governance requirements than sole proprietorships or partnerships, which may feel restrictive to some entrepreneurs.

Which option makes sense?

The decision to incorporate or remain as a sole proprietor or partnership largely depends on the nature and growth prospects of the business. For smaller businesses with modest income, the simplicity and direct control of a sole proprietorship or partnership may be appealing. However, as profits grow or the business takes on more risk, incorporation offers significant advantages, especially in terms of tax savings and personal asset protection.

In today’s tax environment, incorporating can make sense for business owners looking to reinvest profits or defer income to take advantage of lower tax rates. It also provides a level of security that sole proprietorships and partnerships do not offer.

However, the additional administrative costs and complexity should not be overlooked, and entrepreneurs should carefully weigh the pros and cons before making a decision. And when in doubt, the best course of action is to seek out professional tax advice.

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.