Starting a business is both exciting and laborious. One of the first steps in starting a business is selecting between the three main business structures available in Ontario, a) Sole Proprietorship, b) Partnership and; c) Corporation. The following will guide your selection process, but it is always recommended to discuss your specific situation with both an accountant and a lawyer before proceeding further.
The sole proprietorship is the easiest and most inexpensive to set up, the owner (can only be one person) solely controls the business, tax reporting is simple as it does not require a separate corporate tax return, you are subject to unlimited personal liability as there is no separation between the business and owner, can be hard to raise capital via debt or equity financing and lastly, difficult to sell.
Without incorporating, if two or more individuals join together to carry on a trade or business, a partnership is formed. A partnership allows for shared risk between the partners, tax reporting is simple as it still does not require a separate corporate tax return, there is a risk of conflict between partners, either partner can be held responsible for business debts incurred by the other partner and buyouts (when one partner wishes to quit the business) can be problematic.
Should you pick a corporation over the other forms of running a business? Let’s go over the advantages and disadvantages.
The Advantages of Forming a Corporation
The Disadvantages of Forming a Corporation
Advantage #1 – Limited Liability
If the business operates as a proprietorship or partnership, your personal assets such as your house and car can be seized to pay for the business’ debts in the event the business incurs losses or builds up debt it cannot pay.
A corporation is a separate entity to the business owner and has the same rights and obligations under Canadian law as a natural person. As a result, liability is limited to the assets within the corporation. Your personal assets are not normally at risk should the business fail to fulfill its debt obligations.
It is important to note that limited liability does not mean that there is no personal liability. When obtaining a loan or mortgage under a corporation, it is common for the bank/lender to require the directors to sign personal guarantees, which creates personal liability in the event of loan default. In addition, there are limited circumstances where the courts will “lift the corporate veil” to find an individual officer, director or shareholder responsible for bad company acts, including holding them liable for misconduct or debts of the corporation.
Advantage #2 – Tax Savings and Deferral
To encourage and foster the growth of small businesses, the first $500,000 in income that an eligible corporation generates is taxed at only 12.20 percent (as of 2022). It is important to note that this lower tax rate is used to save taxes through a deferral strategy. Without deferral, once the money is paid from the corporation to the business owner, whether via payroll or dividends, the personal annual income taxes paid for the year should be similar to those paid if the business owner operated under sole proprietorship.
Let’s go over an example. Max operates a business and earns $220,000 per year but only requires $85,000 annually to support his lifestyle. If operating under a sole proprietorship, he would pay personal income tax on the full $220,000 in the current year, resulting in approximately $70,000 in payable tax. In contrast, if Max operates his business through a corporation, he could choose to withdraw only $120,000 from his corporation in the current year. This would leave him with approximately $90,000 after paying approximately $35,000 in taxes and the remaining $100,000 would be taxed at the above-mentioned small business corporate rate at 12.20 percent, leaving approximately $88,000 in the corporation. These additional funds can now be used to grow the business, invest in appreciating assets or passive income, withdraw funds as personal income in the future during a less revenue year or be used as a pension fund for retirement years.
Although income splitting has been greatly reduced since 2018, it is still a viable option that can provide some tax relief. Prior to 2018, corporations could issue dividends to distribute business income to a lower-income spouse or family member who would be taxed at a lower rate. As of January 1, 2018, Tax on Split Income (TOSI) rules apply when the income recipient is an adult family member and has not made a “sufficient contribution” to the business. “Sufficient Contribution” is generally considered working an average of 20 hours per week in the business. Adult family members who do not meet this “Sufficient Contribution” test are taxed at a higher rate. These new rules apply to dividend and interest income only. Payroll/salaries by a private corporation are already subject to a reasonable test and if the salary earned is not reasonable to the amount of work done, a tax deduction is not allowed to a business for amounts paid in excess of what is reasonable. TOSI rules do not apply to a related individual after the individual has sufficiently contributed by working an average of 20+ hours per week for a total of 5 years. This applies even if the 5 years are not in succession. So, the corporation can pay that individual dividends at the time the individual is sufficiently contributing and anytime in the future without TOSI rules taking effect.
Another tax incentive is offered to the owners of Canadian Controlled Private Corporations (which are most small incorporated businesses in Canada) is the Lifetime Capital Gains Exemption (LCGE). The LCGE provides tax-free capital gains of up to $913, 630 (as of 2022).
Imagine that Christine operates a restaurant she started and has grown to annual revenue of $600,000. Christine wishes to retire and finds a buyer willing to pay $700,000 for the shares of her business. Since Christine built the restaurant business from the ground up, the initial cost was $0 and there is a gain of $700,000 on the sale. If she operated the restaurant business under a corporation, she would qualify for the LCGE and the full $700,000 gain would be exempt from tax, resulting in $0 in payable tax. In contrast, if she operated her restaurant business as a sole proprietorship, the $700,000 would be taxable capital gain, resulting in approximately $150,000 in taxes.
Advantage #3 – Estate Planning
As discussed above, since a corporation is a separate entity to the business owner, the corporation continues to exist even if the business owner passes away. The ownership of the business would transfer to the shareholders’ heirs. In contrast, sole proprietorships or partnerships cease to exist after the death of their owners.
The continous existence allows for long-term stability and planning. It provides flexibility when transferring assets to others and building a lasting business that can be passed onto the next generation.
Disadvantage #1 – Incorporation and Ongoing Costs
If you retain a lawyer to proceed with the incorporation on your behalf, the common range in costs will be between $1,000 to $2,000 depending on your location and level of complexity.
If you have business partners, it is highly recommended to retain a lawyer to help draft a Shareholder Agreement that governs the business partners’ relationship with each other. The cost for such varies significantly based on the lawyer, number of shareholders, location and complexity, but you can expect to pay between $750 and $3,000.
With respect to ongoing costs, there are annual legal filings which you can do yourself for minimal costs or via a representative which can range between $300 to $500.
Another ongoing cost are corporate annual tax filings which you can do yourself through a do-it-yourself software ($250 to $500) or through an accountant ($1,200 to $2,500).
Disadvantage #2 – Administration Time
Althugh you may hire legal and accounting representatives to help with the administrative tasks, you are still the business owner of a separate entity, and the representatives will require instructions and particulars from you. In addition to your personal filings, you will need to ensure that the corporation’s filings are up-to-date and that the corporation remains in good standing with the government authorities.
Disadvantage #3 – Pay More Taxes in Certain Situations
Although rare, you may end up paying more tax when operating a business under a coporation. This often occurs when the small business deduction is not available, losses are more difficult to use or personal tax credits are not available.
When you operate a sole proprietorship and incur a loss, you can deduct such loss against your other personal income. When through a corporation, the loss can be applied to another year’s corporation tax return to reduce tax within the company only. So, there is a decrease in flexibility by only being able to reduce corporation income in other years compared to having the loss directly reduce personal income taxes in the current year.
In addition, personal tax ceredits available to unincorporated business owners can mean a sole proprietorship pays less tax than a corporation.
To understand what the right choice is for you, please discuss your scenario with both an accountant and a lawyer.
Sukh Law publishes articles for information purposes only and is not intended to constitute legal advice.