There are two main types of businesses: sole proprietors and incorporated businesses. In today's article, I want to go over the advantages and disadvantages of incorporating a business as this is common question we get asked. Below are the pros and cons of incorporating.
Pros
Tax Savings and Deferrals
If you are okay not taking all your income in the year you earned it, you can actually defer some tax. In the end, you will have to pay tax on money you withdraw from your business, however, by deferring tax, you can take advantage of the time value of money. Some businesses use this money to invest in marketable securities. Some businesses chose to reinvest the money in their business and grow it even more.
The other advantage to deferring tax is you can "smooth" your income over the years, so you aren't paying in the highest tax bracket one year and a low bracket the next year. This is a common tax planning strategy.
Better Legal Protection
By incorporating, you add a layer of protection between you and the world. If something were to go terribly wrong and your business was sued or goes bankrupt, your business would be at stake. But your personal assets, such as your home, investments, and personal property would be protected.
There are caveats to this, however. Often banks will ask a shareholder to sign a personal guarantee on business loans. This means that if the business is unable to pay the loan, the bank can come after your personal assets. Having said this, a business that is well established and profitable can usually get any personal guarantees relinquished.
Lifetime Capital Gains Exemption
The lifetime capital gains exemption (LCGE) is a huge tax advantage that small business owners can use when selling their business. Provided that the business meets certain criteria, the owner of the business can sell their shares without paying any capital gains tax up to $883,384.
Estate Planning
Because a corporation is a separate legal entity from you as a person, it continues to live on after you have passed away. Corporations can be a great tool for estate planning for this reason.
Income Splitting
Although this was a significant advantage of incorporating at one time, it isn't as much so with some changes to the income tax act a few years ago. I discuss the new TOSI rules in more depth in this post.
Cons
Incorporation Costs
The cost to incorporate a business typically costs more than registering a sole proprietorship. The cost to incorporate can range from $1,200 to $2,500, depending on the structure needed.
When starting a sole proprietorship, typically a trade name will be registered. The cost for this is under $100.
Annual Accounting, Tax and Registry Costs
With a corporation, the accounting, tax and registration costs will always be higher than that of a sole proprietor. In both scenarios bookkeeping needs to be done, however, the bookkeeping of a corporation is typically more extensive. When filing taxes, a corporation files a T2 return, whereas a sole proprietor files as part of the individuals T1 return. There is significantly more work involved in filing a T2 for a corporation than there is a for T1 for a sole proprietor, generally speaking.
An annual return also needs to be filed with the registry office for corporations. The cost for this is around $75.
Losses
If you run a sole proprietor business, any losses you incur in the business can be deducted against other sources of income, such as employment income. This is one major advantage of sole proprietors. However, this shouldn't be a deciding factor as most people don't start a business with the intentions of turning a loss year after year.
Which is better for tax?
In tax, the term "integration" is used to describe a concept where someone is taxed the same, regardless of the structure of their business and income. For example, if you run a sole proprietorship you will pay about the same amount of tax as someone who owns a corporation and pays themselves a dividend or employment income. Integration works fairly well and there are only slight differences in tax % between the two options. However, with a corporation you get the option to defer paying tax if you don't pay a dividend or take employment income. This means you can hold onto money longer to help grow your business quicker.
Summary
There are many factors that should be considered when making the decision to incorporate. You should carefully consider these pros and cons and discuss them with a professional before making a decision. If you have any questions about the information discussed here, please contact us!