Should you Incorporate Your Small Business?
This is a question that many small business owners ask at various stages of their entrepreneurship journey. The answer is not as simple as it is thought. There are a number of factors to be considered before arriving at any decision in this regard.
If you are starting a small business, it is important to take the time to carefully consider the benefits and risks of various forms of ownership. The choice of entity is largely determined by your personal and family tax situation, your future goals, number of owners and the type of business you want to start.
Proprietorship
A sole proprietorship is a type of business entity in which an individual owns, controls, and operates a business on his or her own. The owner is personally liable for all debts and obligations of the business. This means that in case of default or legal claim, the creditor can come after sole proprietor’s personal assets as well, if business assets are not sufficient to pay the claim. In Canada, sole proprietors do not file a separate return for the business. Rather, business income is reported under schedule T2125 as per of owner’s personal tax return (T1).
Advantages of proprietorship:
- There is practically no cost of starting as sole proprietorship. Any individual can open a business account and operate as sole proprietor under their own legal name. Even if you want to register a separate business name, it can simply be done through a Master Business License. In Ontario, that costs only $60 and is valid for 5 years.
- The business losses can also be written off against the proprietor’s other income if it’s from another business. The business losses can be used to reduce the amount of personal income tax that the proprietor must pay if the proprietor has other income that can be used to offset the business losses.
- Today, most sole proprietorships are small businesses and thus are not subject to many of the those reporting and regulatory requirements that are imposed on corporations. As a result, sole proprietorships have fewer legal requirements than do corporations. However, basic requirements like maintaining book of accounts, proper recordkeeping, applying accounting principles etc. must be followed by all businesses, irrespective of their legal form.
Disadvantages of a proprietorship:
- The biggest disadvantage of a proprietorship is its unlimited liability. The owner must be personally liable for all debts and obligations of the business, which puts the owner’s personal asset at risk if the business fails.
- In a sole proprietorship, if the owner dies, the net business assets pass to the heirs. The heirs are also personally liable for the business’s debts and obligations, so they must be able to personally discharge the business’s debts. Likewise, business assets will be received by heirs through a costly probate process.
Partnership
A partnership is an unincorporated business structure in which two or more people join to carry on a business or profession under an agreement to share losses and profits. A partnership agreement is usually a legal contract that sets out how the partnership will be formed, how the partnership will operate, how the partners will share the profits and losses, and how the partnership will be dissolved. In Canada, for tax purposes, all partners report respective share of income and expenses as part of their own personal tax returns.
Advantages of partnership:
- Partnerships are also relatively simple to set up. The setup costs of a partnership are relatively low. A partnership can be formed even with a verbal agreement. However, it is recommended to have a written agreement in place to avoid future disputes.
- Partnerships are less regulated than corporations and can be set up to take advantage of the many tax advantages that can arise from them. They are also flexible, as they can be created for almost any purpose.
- The business losses can be written off against the partners’ income from other businesses. The business losses can be used to reduce the personal income tax that the owners pay if they have other income that can be used to offset the business losses.
- A partnership allows an individual to benefit from the experience, knowledge, and skills of other individuals who are partners.
Disadvantages of a partnership:
- With exception of Limited Liability Partnership that is allowed in very limited cases, all the partners in a general partnership are jointly and severally liable for all the liabilities of the partnership. This means that if a partnership has two owners (A and B) with 50% ownership each, the credits can come after 100% of assets of Partner A and B, if business assets are not sufficient to settle the business obligations.
- From tax point of view, a partnership is a flow-through entity. This means that each partner will report their portion of partnership income and expenses in their own personal tax returns. If there is wide difference in personal tax situation of two partners, both may have varying level of motivation to grow business.
Corporation
By forming a corporation, a separate legal entity is created that has its own legal existence and files its own tax returns. The owners of a corporation are called shareholders. Shareholders elect board of directors to oversee the corporate governance. Management of corporation can be different from its shareholders. In case of small business, most of the time, the shareholders are not only directors but also run day to day matters of the business. However, this structure helps in segregation of duties and creating a firewall between business assets and personal assets of shareholders, in case of legal claim.
Advantages of incorporation:
- A corporation has limited liability, so if the business fails, the shareholders have no personal liability for the debts and obligations of the business, and they have the same liability as the owners of the corporation. In case of small businesses, this benefit is often nullified because banks typically require personal guarantee of owners when granting loans or line of credit.
- In Canada, a corporation that meets certain requirements can avail Small Business Deduction up to $0.5 Million which reduces their tax rate as low as ~12.5%. In comparison, a sole proprietor earning $0.5 Million will be taxed at more than 50%.
- Since corporation is a separate legal entity that files its own tax returns, shareholders have an option not to draw funds as salary or dividends in the years when the owner already has higher personal income. For example, Corporation A is 100% owned by Mr. A. In a particular year, Mr. A sells an investment condo he personally owned resulting in capital gain of $150,000. This will place Mr. A at a high tax bracket. Any further income earned by Mr. A in that year will be taxed at the higher marginal rate. If Mr. A would have been a sole proprietor, he would have had no option but to include business income in his personal tax return in the same year. However, if the business is run under corporation, Mr. A can choose not to draw salary or dividend in that year and thus lower his tax liability.
Disadvantages of incorporation:
- Incorporation can be relatively expensive and difficult to set up. Likewise, there are far more maintenance requirements for a corporation (such as minute books, resolutions etc.) than a sole proprietorship or partnership.
- Corporations cannot write off business losses against their shareholder’s personal income.
Thus, there is no one-size-fit-all answer regarding which form of ownership a business should adopt. It is recommended to sit with an accountant and discuss these options in the light of your own personal and family situation as well as your future goals. Finnection is a trusted partner for small business owners to make such decisions. You can book an appointment with us at following link.
Disclaimer: Above information is subject to change and represent the views of the author. It is shared for educational purposes only. Readers are advised to use their own judgement and seek specific professional advice before making any decision. Finnection Inc. is not liable for any actions taken by reader based on the information shared in this article.