Should You Incorporate Your Small Business in Canada: Pros and Cons

One of the most common questions that I get asked as a accountant and a financial consultant is whether you should incorporate your Canadian small business. And in this video I am going to help you answer that question by going over the pros and the cons of incorporation. My name is Veronica Canna. I am a cpa, a CFA, and the founder of Montreal Financial, where you can find lots of resources for your small business. And in fact, I have received so many questions about incorporating. I also have a book called Fast Start yout Corporation which helps small business owners to set up their corporations properly right from the start. I will leave a link to to the book in the description of this video. Okay, so first of all, let us define what a corporation is. And what a corporation means essentially is that it is a separate legal entity, in contrast to a sole proprietorship or a partnership, which are essentially extensions of an individual. And because a corporation is separate, a separate legal entity, there are all kinds of legal and tax consequences. And one other thing to keep in mind is that in Canada there are really essentially three types of structures. If you are a for profit business, that is a sole proprietorship and a partnership, both of which are unincorporated and and a corporation. Unlike the US which has several different types of corporations like S. Corps and C Corps, in Canada, there is only basically one type of corporation. There are differences that are a little more complex and beyond the scope of this video. Okay, so let's start by going over the pros of incorporating your business. And the first one is limited liability, which you may have heard and what that basically means. Because a corporation is a separate legal entity, if you are sued or if your business is sued, they can really only go after the assets of the corporation, unlike with a sole proprietorship where they can come after your personal assets as well, because there is no distinction between you and the sole proprietor. So this is a very this is one of the primary reasons that people incorporate. But it should be kept in mind that you can also get liability insurance to replace the limited liability offered by a corporation and continue to operate as a sole proprietorship. So it is something to talk about with an insurance company. If you perhaps don't necessarily want to go the corporation route, the next reason that you might want to incorporate is to seem more credible, more professional. And in certain cases your customers might only deal with a corporation. Alternatively, if you're looking for loans or funding or investors, you might also have to set up a corporate entity. So having a sole proprietorship wouldn't even be an option in this case. The next Reason, and perhaps the most popular reason for owner managers who are contemplating incorporation are tax deferral and tax savings opportunities that a corporation offers. Okay, so let's look at an example with a sole proprietorship, let's say you have business profit of $100,000. You will simply be taxed at an average tax rate of 30%, approximately in Ontario. So that will mean that you'll pay $30,000 in tax and you'll be left with an after tax amount of $70,000. A corporation, on the other hand, allows you to defer your taxes, assuming that you are able to take out less than the total profits in the corporation. And so in this example, we'll see your business profit is $100,000 and the amount that you need for your personal living expenses is only $60,000, which means you can leave the rest in the corporation. So in this scenario, our profit after deducting a salary of $60,000 is $40,000. On that $40,000, you are going to pay a 12% tax amount of $4,800. And the personal taxes that you will pay on the salary at 22% on the 60,000 will be about 13,200. So this means when you add up these two amounts of 4813,200, you get total tax paid in the corporation of $18,000. And therefore, when we compare this to the $30,000, you have a tax deferral of $12,000 and you have $35,000 left over in the corporation to invest. Now, it's important to note that this is a tax deferral, so you will have to take this money into the corporation at some point in the future and pay taxes on it at your personal tax rate. But this could be in the future, and in the future you might take out an amount that actually is lower and so therefore has a lower average tax rate. So you can see in this example what you have is both tax deferral. Tax paid today is higher than tax paid in the future because of the time value of money and also potential tax savings. Because you could take out, by taking out a lower amount, you might have a lower average tax rate. So this is one of the significant benefits of having a corporation, particularly when you're making more than you need for your personal living expenses. So hopefully that makes sense. But don't hesitate to ask me a question in the comments and I will try and explain that further. The next reason that you might want to incorporate is based on the lifetime capital gains exemption and what this Means is as the owner of a small business business corporation, you can sell your shares to a third party and $1,000,000 of the proceeds of the capital gains that you earn on that sale are actually tax free. This is an incredible tax savings opportunity, particularly if you're building a small business that has some value and that you can sell in the future. And so a lot of tax planning goes around this. You would, if this is your intention, you would want to make sure that your small business corporation fulfills all of the criteria to be a qualified small business to take advantage of this particular program. Okay, so the next reason you might want to incorporate as mentioned, is that as a corporation you might have better access to capital. This again seems you makes you seem more professional and credible. And you can submit applications for loans to banks to for specific programs such as the bdc and there's all kinds of loan programs by province that are offered for specific types of businesses. So I encourage you to look into that. And additionally, if you do want investors in your corporation, you would have to set up a distinct share structure so investors can participate in the growth of your corporation. And again, all of this requires some special tax planning. So you would want to seek out a tax specialist to help you with this. The next reason to incorporate closely related to the lifetime capital gains is that a corporation has existence outside of its shareholders. So that means if the owner of a corporation dies or wants to retire, it is very easy to simply transfer, sell the shares to a family member or to a third party without having to dispose of the individual assets, et cetera, which can be significantly more complex and time consuming. Okay, so now let's look at some of the cons of incorporation. The first and the second are very closely related. So let me talk about both of them. A corporation essentially just has more administration. It is a more complex entity. So there is more paperwork that you have to do and more tax obligations that you have and by extension higher costs. So first of all, when you set up your corporation, there is a cost that is associated with that. There are services. There's one called owner that I will link to in the description section, which is pretty low cost associated with rvc. And there's a bunch of other online services that you can use, or you could hire a lawyer which would cost significantly more, or you could do it yourself if you feel confident. There's lots of how to guides and if you go to Industry Canada, you'll see some instructions on how to do that, how to set it up yourself. Now in addition to the one time set of fee. It is recommended when you have a corporation to have an accountant. And you might have one as a sole proprietorship, but a corporate accountant will be more expensive depending on how much of your tax filings and compliance and bookkeeping that they take care of. The other thing that I recommend, especially if you're small, you're not that complicated, you only have a few transactions a year. I recommend doing your book bookkeeping yourself. It's very easy, particularly with accounting software. I do highly recommend that everybody who has a corporation get accounting software. Unlike a sole proprietorship where you can simply use a spreadsheet. And that is totally fine because you only really need a profit and loss statement for a corporation. You also need a balance sheet and you need some additional reporting. So it is important that you have all of your accounting very well organized. But again, with accounting software you could do it yourself. Save some costs on an accountant and then get your accountant to do your year end filings. And there's several tax obligations which include corporate tax returns, if you pay yourself a salary, salary declarations, dividends, if you take dividends out of the corporation, and then sales taxes, gst, HST and qst, which will be pretty much the same, same as if you're a sole proprietorship. Okay, so the next downside of having a corporation is that corporations tend to be complex as mentioned. And transactions within a corporation can be very complex, which makes it more difficult for the lay person to understand. So having a good accountant is very important. And finally, the last downside of a corporation that I'm going to talk about are with respect to losses. If you are a sole proprietorship or a partnership and you incur loss in your business, which is not uncommon in the first couple of years of your business, or if you have a bad year, you can offset this against other sources of income. With a corporation, because it is a separate legal entity, the losses are contained to the corporation. So you can carry the losses forward within the corporation. Apply it to years in the future when you do have income, so that is certainly a benefit. However, you cannot apply it against other sources of income on the personal side. And you may be able to amalgamate your corporation with another more profitable corporation, but that is the subject of of more advanced tax planning. Whether or not you should incorporate depends on your situation. On the unique aspects of your situation, you might decide that it makes sense because you are earning far more than you need for your personal living expenses. You need limited liability, but you may be off put by the additional costs and the additional administration. And often it comes down to is it necessary? Is your business growing? Do you have employees? Are you going to want to bring on investors? Are you going to want to take out loans? These are all good reasons to incorporate. If you are just a one person owner manager with a small service based business with a lot of the RSP room, you might want to consider first drawing down on your RRSPs because that will give you similar tax deferral opportunities as a corporation without the stress and without the costs involved. So if you have any questions, don't hesitate to leave it in the comments. I will try my best to answer it. I also offer consultations and I think my book is super helpful if you are in the early stages of starting a corporation. So I hope this was helpful. Please like and subscribe and have a great day.