Updated: Nov 4, 2020
If you’re like most unincorporated small business owners or a professional whose regulatory body allows incorporation (known as a Professional Corporation) you’re likely considering whether or not to incorporate and, if so, when is the best time.
While it’s true that incorporation does deliver terrific tax benefits and some creditor protection from your personal assets, there are pros, cons and caveats to incorporation that might affect your decision. Let’s look at them.
Cash Flow If you need all of the profits from your business to support your personal cash flow needs, incorporation may not be for you as the cost of setting up and maintaining the corporation could outweigh any tax benefits. On the other hand, if you are financially able to retain some profits inside the corporation, you could derive significant tax deferral and potential tax savings.
Taxing Questions If you are just starting your business, incorporation should probably wait because losses incurred by an incorporated business can’t flow through to shareholders. In the early stages of your business, you’re likely better off using losses personally against other income. Once your business begins to earn income in excess of your own personal lifestyle needs you may begin to benefit from the ability to defer your tax liability to a future period and benefit from potential tax savings (in most provinces)..
Creditor-proofing Personal Assets Corporate creditors can generally only go after assets owned by the corporation. However, banks and other suppliers often require small business owners to personally guarantee corporate liabilities and corporate directors may be liable for many types of unpaid debts such as outstanding income tax, HST, GST and employee source deductions. Incorporation may provide some creditor protection, but only if properly structured, so speak to an advisor to ensure you are protected.
Income splitting by paying dividends on shares held by other family members can result in overall tax savings where marginal tax rates within the family vary due to different levels of income. Recent amendments to the Income Tax Act (Canada) make income splitting more difficult and in some cases is no longer possible so existing structures should be reviewed to ensure they are still compliant and new strategies should be mindful of these changes. Salaries that are not in excess of a reasonable amount continue to be an effective way to income split.
Deferring certain expenses. For example, you can deduct employee bonuses for tax purposes before year-end but are only required to actually pay out the bonus after yearend (certain restrictions apply).
Leaving assets in the corporation where they will continue to grow on a tax-deferred basis until you choose to withdraw them.
Creating a registered pension plan and tax-deductible group health and life insurance plan for you and your employees (which could include family members).
Choosing a fiscal year spanning any 12-month period. Select a fiscal year that coincides with business or cash flow peaks or when corporate expenses are higher (potentially reducing your tax bite).
Structuring your corporation to continue after your death for estate planning purposes.
There are certainly potential benefits to incorporation but incorporating also comes with costs – from initial setup and legal costs to ongoing requirements for tax returns and corporate resolutions – and other legal requirements. Be sure to talk to your legal, tax and professional advisor before you do.