To Incorporate or Not Incorporate

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(Thursday, December 17, 2009)

TO INCORPORATE OR NOT TO INCORPORATE

Summary

What business structure should I use when I start my business? When should I incorporate?

Article

There are three “normal” business structures in Canada. The three choices are: sole proprietorship – an individual business owner not incorporated; partnership – two or more individuals not incorporated; and finally a corporation – a separate legal entity that can have one or many individual or corporate owners. Each of these choices offers advantages and disadvantages. Some of the considerations that come into play in choosing which structure works best for you may be the tax savings, legal liability, start up costs, available business opportunities and personal situations.

A sole proprietorship is not a separate legal entity from the individual operating it. This can have ramifications if the business is sued legally or unable to pay its debts. In this case the owner is generally liable for any amounts due to creditors and personal assets can be lost. There may be a tax advantage to using this form of business in the early years when losses are occurring if the owner is still receiving income from other sources. The losses from a proprietorship may be used against other income such as employment, rental or pension income.

The proprietorship structure has the advantage of minimal start-up costs. Depending on the size and nature of the business, a separate bank account may not even be required. This form of business is often used in the start-up years of a business when profits are not as likely and the owner is using his/her own funds for financing the business. When the business starts to be more successful and tax planning is an issue, a proprietorship can be rolled into a corporation after the fact with little or no tax consequences, if the right elections are filed. Thus, the business owner has the advantage of having the flexibility to change at a later date when their business changes.

A partnership is very similar to a sole proprietorship; the only difference is that there are two or more individuals involved in the business. It, too, can have minimal start-up costs, tax advantages to early period losses and the ability to become a corporation at a later date. It has the added advantages of sharing both management responsibilities and the financing of the initial start-up of the business. Since ownership investment and time constraints are shared between more than one individual it can take the burden off a single person trying to “go it alone”. The downside can be loss of control over managing the business on a day-to-day basis. A good understanding of each partner’s duties and responsibilities are critical to avoid disputes. Many times what starts as a happy, highly successful relationship deteriorates into a bitter feud when things are not going well or as one partner believes they should. Dissolving a partnership is often a costly and stressful exercise. A carefully crafted and thought out partnership agreement should be a necessity for all partnerships.

The third business structure is a corporation. Unlike the other two types, it is a separate legal entity that is created when incorporation papers are submitted to the appropriate government authority. It gives the owners (otherwise known as shareholders) the distinct advantage of limiting their personal liability for the debts and legal affairs of the business. A shareholder can still be sued personally in cases where source deductions and withholding taxes are not paid if they operate in the capacity of director or officer and have control over the finances and financial decisions. But, the corporate entity does provide some protection for the shareholders from most debts of the business.

The corporate structure allows the business owner to truly separate his/her business and personal activities, thus limiting liability. However, for financing, leasing premises or equipment banks can, in some cases, require it for bonding, insuring and labour issues. A person buying can assume hidden liabilities an existing company for the new shareholders may be inheriting hidden debt or liabilities not known by the purchaser at time of purchase. Extreme care should be taken when buying the shares of a limited company and a professional accountant can earn their fees ten fold in preventing additional tax costs or hidden liabilities.

There may be tax advantages to using a corporation if the profits of the company are adequate. The tax rates on active small business income are coming down each year and are currently around 15.5%. Not a bad tax rate. This rate is available on the first $500,000 of active small business income. Dividend and wage combinations can be utilized when paying remuneration to shareholder/managers. On sale of the shares of the corporation, the corporation’s shares may also qualify for a special small business capital gain exemption of up to $750,000. This exemption is very much dependent on not only the individual’s personal tax situation, including deductions claimed as far back as 1987, but on whether the corporation qualifies for the exemption. It is extremely important to have a professional accountant involved if shareholders of a small business are considering selling their business.

The choice of business structure is an individual decision involving many factors. Some factors will have more weight than others and the weight given will vary from individual to individual. When starting up a new business it is extremely wise to review all your options.

Joyce Smith, CGA., CFP is president of Joyce A. Smith & Associates Inc. located on Bowen Road, Nanaimo, British Columbia. The company specializes in technology solutions, financial and personal planning and management consulting for business.