Have you been running your business for a while and are now considering whether to incorporate? As with any major decision in life, it’s important to research your options thoroughly before you make a decision. Take a few minutes to read below for a comprehensive list of pros and cons on incorporating your business.
Lower Corporate Tax Rate
Business income earned by a corporation is taxed at the corporate tax rate for the province in which you run the business. However, if your business is unincorporated, the income earned by a self-employed person would need to be reported on the personal tax return and taxed at the applicable marginal tax rate.
One of the benefits of incorporating your business is that the income earned is taxed at the lower corporate tax rate in comparison to the marginal tax rate on the personal tax return. You may want to discuss with your accountant for the optimal income amount in which incorporation would be advantageous. Here’s a basic example to illustrate the idea:
Let’s suppose you are self-employed and are profiting $100,000 from your business each year. You live in the province of Ontario and are wondering whether it would be beneficial for you to incorporate your business.
As a self-employed person, your personal tax rate and taxes payable on the $100,000 are as follows:
Personal marginal tax rate: 43.41%
Average tax rate: 24.93%
Taxes payable: $24,931
As a corporation, the corporate tax rate and taxes payable on the $100,000 are as follows:
Corporate tax rate: 15%
Effective tax rate: 15%
Taxes payable: $15,000
By incorporating your business, you have effectively deferred $9,931 of taxes.
Lifetime Capital Gains Exemption
Unless you have a business background or you’ve spoken to an accounting professional, you may not have heard of Lifetime Capital Gains Exemption (LCGE). LCGE is a tax benefit that is only available to the owners of a qualified corporation at the time when the business is sold. Each individual is entitled to a lifetime $800,000 deduction against capital gain when disposing of shares (ie. ownership) of the corporation. This is known as the Qualified Small Business Corporation (QSBC) shares.
For example, let’s assume your business is worth $500,000 and you are seeking a potential buyer. If the shares of the corporation you are selling are QSBC shares, then the entire capital gain on the sale of business could be exempt from tax.
This tax benefit is only available to owners of a corporation and is not available to a self-employed person.
If you have a spouse/common-law partner or children, you can achieve income splitting by hiring them to work for the corporation. Income splitting effectively shifts income, that would otherwise be taxed at a higher tax bracket (such as yourself), to a lower tax bracket (such as your spouse/common-law partner). This requires you to be the higher income earner and your spouse to be the lower income earner in order to create a discrepancy due to the difference in tax brackets.
Let’s suppose you live in Ontario and you are the higher income earner. Your spouse does not have other sources of personal income. By distributing $100,000 from the corporation to yourself, the personal tax implication will be:
Your marginal tax rate: 43.41%
By splitting the income and distributing $50,000 to you and $50,000 to your spouse, the personal tax implication will be:
Your marginal tax rate: 29.65%
Your spouse’s marginal tax rate: 29.65%
The marginal tax rate on the same amount of income is significantly reduced through income splitting.
Note that in order to accomplish this, the salary/dividend paid to your spouse or children each year must be “reasonable”. This generally means that you should pay an amount that is considered reasonable based on the services they provide to the corporation.
When your business is incorporated, the corporation and you are considered two separate legal entities. This allows any obligation created by the business to remain within the corporation, thus your personal assets are protected. Generally speaking, your liability is only limited to the amount you have invested into the business. However, if you require financing, banks generally require a personal guarantee on loans for new businesses. In addition, you should note that directors of the corporation can still be held personally liable for certain areas of the corporation such as GST/HST and Payroll.
There are several types of cost involved with incorporating your business:
- Registration costs: There is a fee to file the articles of incorporation with the appropriate government department. You may also incur a professional service fee by hiring an accountant or lawyer to assist with the incorporation process.
- Bookkeeping costs: By law, you are required to maintain proper record keeping for your corporation. You are also required to have proper bookkeeping in order to prepare financial statements, which are documents needed to prepare the corporate tax return.
- Corporate tax filing fees: You may need to hire an accountant to prepare the corporate tax return and GST/HST return. If you have employees or distribute dividends during the year, you will also need to file a T4 and/or T5.
- Legal fees: From time to time, you may require additional legal services to prepare documents such as a shareholder agreement and corporate resolutions.
Generally, the more profit you earn in your business, the more advantageous it is to incorporate it, as there are more tax planning opportunities. Though, if your business is in a loss position, where it is earning minimal profit, it might not be an advisable option for you. Of course, there are many different angles to consider, so you are encouraged to speak with your accountant about the decision to incorporate, as this is a long-term commitment.