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Should I Incorporate my Small Business?

Here is another entry from Ed Rempel regarding if you should incorporate your small business. I was asked this question from Qubikal, but I asked Ed to answer as he has experience in this field.

This topic was requested by a reader and is a question I am often asked. The issues are all tax and legal, and can be intimidating. However, they can be summed up with a few questions.

  1. Is there a reasonable risk my business might be sued some day?
  2. Does my business make a good income that I don’t need to spend or reinvest now?
  3. Can my business be sold for a significant amount of money?

Your business can be either a corporation or a sole proprietorship, which means your business is you and taxed on your personal return.

1. Risk of being sued:

One major advantage of having your business as a corporation is that if you are sued, you can usually avoid being liable personally. At worst, usually only the assets in your corporation can be lost if you lose a law suit. Law can be somewhat arbitrary, so you might well lose even if you didn’t really do anything wrong. However, some businesses are much more likely to be sued than others.

2. Tax deferral:

Corporation tax and how it fits with your personal tax can be complicated, but can also be summed up into one major concept. If your business makes $100,000 and you spend the money, all the tax rules are designed so that you pay about the same total tax whether you business is a sole proprietorship or a corporation.

The advantage of a corporation is a tax deferral. The income is initially taxed in your corporation at a lower rate, and then you pay the extra when you take the money personally.

The tax rate on a small Canadian corporation is about 22%, which is about the same as the lowest personal tax rate on incomes under $37,000/year. If your personal taxable income is not over $37,000, then there is not really an advantage of having a corporation.

The profit in a corporation is taxed at a low rate, but you will need to pay it out to yourself one day. Your corporate income can be paid to you as a salary (or bonus or management fee) or as a dividend. If you pay it as a salary, then your business gets a deduction that eliminates the corporation tax on that amount and means you are taxed on it personally.

Have you ever wondered why a dividend is grossed up by 45% on your personal tax return and you then get a 19% credit? What does all this do? The purpose is to put yourself into the same position whether the income was in your business or taxed personally.

If you pay yourself a dividend, then your corporation does not get a deduction, so it has to pay tax on that amount of income. When you gross up your dividend by 45%, this is supposed to approximate the income of your corporation on the dividend before tax. Then the dividend tax credit is supposed to approximate the income your corporation paid.

In short, whether you pay yourself a salary or a dividend, the total tax paid by you and your corporation will be about the same as it would be if you were not incorporated.

There are some planning opportunities in that you can pay yourself an optimal amount (whatever amount you want each year) and you can create another small deferral of tax by one year by choosing the best year-end for your corporation.

The main advantage, however, is if your business makes a profit and you don’t need the money. Therefore, you can leave the profit in the company – either to reinvest in your business or buy investments in the company (or a holding company). The longer you can leave it there, the better. Once you pay it to yourself, the tax advantage disappears.

3. Sell your business:

If you sell your business one day for $500,000 (or $1 million if you spouse owns half), this amount will be tax free if your business is a corporation and meets a few rules.

Making your business saleable is an entire topic. If your business is just you and your relationship with your customers/clients, then if is hard for anyone to buy it. But if you expect to be able to sell it one day, then having it as a corporation can save you a lot of tax.

What happens if you are doing the Smith Manoeuvre? How does this affect your decision on whether or not to have your business as a corporation? This will be a future topic.

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About the author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching.

Ed has written numerous articles to educate the public and his clients on his unique insights into strategies that actually work, instead of the “conventional wisdom” common in the financial industry.

Ed has trained more than 200 financial advisors and is considered the Smith Manoeuvre expert in the Toronto area. He has received accolades from Frasier Smith in his book “The Smith Manoeuvre” for customizing this strategy for hundreds of clients. His extensive experience in tax and finance has placed him in high demand. Ed’s team collaborates on each of their clients to help them create financial security and freedom.

{ 24 comments… add one }
  • The Financial Blogger May 24, 2007, 8:05 am

    Well developed topic. I would add that if you have a small company, you might be better of to run it as a sole proprietorship and combine income/loss. Technically, you a are able to deduct several expenses (car lease, gas, computer, phone, part of your mortgage) from your company income. Therefore, you could create a loss for the first few years and drop your personal income. You won’t be able to do so if you incorporate your business. However, you are only allow to declare loss if the business is going to be profitable at one point. The government is not that stupid!
    FB

  • FourPillars May 24, 2007, 10:35 am

    MDJ, have you incorporated this site yet? :)

    Mike

  • ThickenMyWallet May 24, 2007, 7:48 pm

    Good post. A couple of points:

    1. You run greater audit risk being a sole proprietor with high income than an incorporation with low taxable income.

    2. The 22% tax rate is the federal portion of corporate taxes. However, for a Canadian Controlled Private Corporation, the federal portion is 13.12% (plus the applicable provincial rate) for the first $400K of taxable income.

    3. Tax planning opportunities are greater in a corporation than a sole proprietorship since you can income split on both dividend declarations and a on legit work performed by your spouse/kids (what is legit is a contextual question). By 2010, in Ontario, dividends paid by a CCPC will be on the same tax level as dividends paid by publicly traded companies.

    Coincidentially, I have a post tomorrow about Universal Life Insurance and self-employed (www.thickenmywallet.com). Thanks.

  • FinancialJungle.com May 24, 2007, 9:47 pm

    Question 1: When I invest in stocks inside a corporation, does the corporation benefit from the capital gain tax treatment?

    Question 2: What’s the cost difference between hiring an accountant to do:
    – corporate tax return + personal return
    – sole proprietorship return (personal return included)

  • The Financial Blogger May 24, 2007, 11:11 pm

    FJ, for your 1st question, I’m not quite sure about the answer (I remember reading it while during my CFP but it’s all blank now;-). However, for question#2 personal report cost between $30 to $100 depending on the complexity of your personal stuff (rrsp, stock trading, dividend, dependent, etc). For sole proprietorship and company it’s the same. One of my relative pays about $1000 for everything in regards to a corporation. On my side, I pay about $400 for myself, my wife and my sole proprietorship. In both cases, it’s not that expensive considering having your tax done properly!

  • FrugalTrader May 24, 2007, 11:55 pm

    FourPillars: LOL, no, not yet. ;)

    Guys, I apologize for the lack of involvement in the comments/emails, i’m currently in the states on business.

  • ThickenMyWallet May 25, 2007, 12:57 am

    FJ- generally speaking, one half of the taxable capital gain (less one half of any applicable capital loss) is included into the corporation’s income and taxed at the corporation’s regular rate. However, as a general rule, if the corporation is deriving more than 10% of its income from passive income sources (i.e. it does nothing more than hold stocks and bonds), the corporation will be taxed at the passive income rate of 49.79% and the CCPC federal tax rate of 13.12% no longer applies.

  • Qubikal May 25, 2007, 2:10 pm

    FT – Thanks for posting the topic. The article (and all comments) are very informational for my current situation.

    ThickenMyWallet – Great points on using the Corporation as an investing vehicle (in addition to the regular course of business.

    Could you provide further information about paying dividends via CCPC being treated the same as public co dividends? And will this apply to other provinces – ie. BC?

  • Ed Rempel May 26, 2007, 6:27 pm

    FJ – A basic personal return may be $80-120 at H&R Block and possibly $20-40 more to add the schedule for a sole proprietorship into your personal return. A corporate return will probably cost $250-800. The other cost is that banks will generally charge you $10/month or more higher for a corporation account vs. a personal account.

    In total, you should expect it to cost $400-1,000/year more to maintain your corporation. It will probably cost you $400-1,200 to setup the corporation. For these reasons, you are usually best to stick with a sole proprietorship unless you have a specific reason, such as the 3 in the article, to make it worthwhile to have a corporation.

  • Ed Rempel May 26, 2007, 10:53 pm

    Hi Qubikal,

    If you are thinking of investing in your corporation, you may be misunderstanding this. The low tax rate in your corporation comes from the “small business deduction” which applies to the first $400,000 of active business income in your corporation, but not to investment income in the corporation. Investment income in the corporation is taxed at a high rate similar to receiving the same income at the highest personal tax rate.

    There is no advantage of receiving investment income in the corporation. The advantage is that once you get into higher personal tax rates, you will pay less with corporation tax, which leaves you more money to invest. You will pay the extra tax eventually when you withdraw from your corporation. This tax is only deferred, but you can make money investing the savings in the mean time.

    Dividends from your corporation will be taxed favorably on your personal return, just like they were paid from a public company. However, this means your corporation won’t get a deduction for paying the profits to you. The total tax is similar whether you pay it to yourself as a salary or a dividend.

    There are advantages of paying yourself a salary, especially that you get RRSP contribution room. Since the first $37,0000 of personal income is at a similar or lower tax rate than the small corporation rate, usually the most effective solution is to pay yourself a salary of $37,000 plus any other tax deductions you have (like RRSP), and then keep the remaining profits in the company (unless you need the cash flow to cover your personal expenses).

    Ed

  • qubikal May 27, 2007, 1:40 pm

    Ed – thanks for clearing a few points up.

    What I’d like to know is what is the best way to grow my money if it is left “tax deferred” within the corporation? (other than looking at entrepreneurial opportunities?)

  • Ed Rempel June 8, 2007, 9:33 pm

    Hi Qubikal,

    That’s an involved question. However, you can invest normally with tax-efficient investments inside your corporation. You will pay similar tax on future investment profits compared to if you had held same investments personally, but you will have more to invest, since you paid less tax on the original business income.

    If your investments are tax-efficient, then you can still defer future tax as well.

    Depending on the likelihood that your business would be sued or sold, you may be better off transferring your cash to a holding company before investing. This can essentially be done tax-free in most cases.

    The other option is to focus on strategies to get the cash out of your corporation with a minimum of tax. For example, you can use personal leverage strategies and take extra cash out of the company to pay the interest on the leverage loan.

    Ed

  • FrugalTrader June 8, 2007, 10:17 pm

    Ed, i’ve read that if you’re the only “employee” of the corporation, and the corporation is sued, you can be personally liable. Any truth to this?

  • Ed Rempel June 9, 2007, 12:48 am

    Hi FT,

    This is a legal question, not a financial planning question. The general answer is that if you operate so that your customers or clients realize they are clearly working with your company, then you are probably protected.

    But if they can argue they were dealing with you personally or that you personally damaged them in some way, then there is still some risk. There are no guarantees in law.

    If your business is the type that litigation against you is somewhat likely, then it is adviseable to incorporate and to also protect your assets by putting them into a holding company or spouse’s name, or by investing in seg funds (this is the one time seg funds may be worthwhile) or keeping assets fully leveraged.

    If you have no significant assets that can reasonably be seized, then you are also much less likely to follow through suing you.

    Ed

  • Incorporation Gyan May 23, 2008, 3:33 pm

    Incorporating a business have both advantages and disadvantages. Advantages comes as liability protection and corporation life does not cease. Also capital can be raised through sale of stock. Disadvantage is that double taxation and need of professional assistance in taxation and legal matters.

  • dwu August 18, 2008, 2:16 pm

    Can anyone please comment on what is the “mechanics” for issuing common shares once a CCPC is established? Is there a generic form to be completed or do we keep track of this using our minute book? Also my second question is that I setup a corporation on my own to trade Forex and equity options. I understand that all my gains will be taxed as business income in this case?

    thanks

  • Louise September 27, 2008, 5:17 pm

    We are in the process of setting up an senior day care center and are going back and forth about incorporating or just staying general partnership. We were wondering if we could register as a general partnership for now and as the business grows and becomes successful then incorporate.

    • FrugalTrader September 27, 2008, 8:25 pm

      Louise, corporations will provide liability protection for your seniors day care business, which is the biggest reason why I would incorporate in that circumstance.

  • Colourful Money April 29, 2009, 4:31 am

    One thing I will say is not to register for a GST unless you’re making the numerical threshold (the number escapes me now). It will save you a lot of headache, believe me, so much unnecessary paperwork and not worth the time!

  • MikeG September 8, 2009, 2:24 pm

    Just adding some newer information to the article, you can now have a one time exemption of 750,000. So sell your business for 1.5 million if you plan to do this kind of thing. http://www4.agr.gc.ca/AAFC-AAC/display-afficher.do?id=1204207744229&lang=eng

    I personally say, just never sell, make that money till the end of time.

  • carl October 3, 2009, 9:54 am

    How about the removal of funds at the max 35000 per year as a tax strategy. Isn’t it true that this gives you a way of removing dollars later from the corp and minimizing the personal tax hit ?

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