As our company regularly conducts training for a variety of organizations that support new or soon to be established businesses we tend to get asked the same questions frequently. One of the most regular questions we get asked relates to incorporation, specifically; when is the right time to incorporate?
Now, for clarity we are not lawyers, so this cannot be constituted as legal advice but from a financial perspective there are advantages to incorporating. Largely, new or soon to be businesses are looking for a magic number that dictates whether the time is right to incorporate or not. The reality of that is there is no such number, so stop looking for one. There’s a couple specific questions you need to consider first;
- Are there potential issues with liability specifically related to your business?
- How much money do you need to support your lifestyle?
- Are you organized enough to handle the added requirements of incorporation?
The main reason that businesses incorporate is limiting liability. When you incorporate, you transition from being wholly liable to only partially liable (again, there are intricacies here). By incorporating, you are actually creating a whole new entity, said differently, it’s like you’re creating a whole new person in the legal and tax realms. Upon incorporation, you become a shareholder, as a shareholder your liability is limited to the amount of money you have invested in the company. If for example, you invested $5,000 to purchase a computer to be a marketer, that’s the extent of your liability (there are exceptions but we’re attempting to keep this simple).
If you get sued by a customer who claimed you ruined their business with poor marketing, your at-risk amount is only $5,000. In other words, the company has no other assets that your customer can grab onto.
As an unincorporated business, all your personal assets are at-risk, so that same customer could go after your house, car, bank accounts, etc.
For clarity, corporations must elect directors who have a fiduciary duty to ensure the company stays out of trouble and can be sued if something goes off the rails, and you should connect with a lawyer or do your research to understand this more clearly.
Financial Benefits of Incorporation
The main tax benefits of incorporation relate to the fact that the corporate tax rate is much lower than the personal tax rate. If you earn $150,000 a year as a salary from an employer, a portion of the earnings are taxed between 45-47% (this differs slights depending on province/time of year). However, this same $150,000 if earned through an incorporated entity would pay about 16% (if the business makes less than $500,000 annually). This advantage is what is referred to as a tax deferral.
Basically, if your incorporated business earns $150,000 per year, but you’ve determine you only need a gross income of $60,000 you can choose to pay yourself this $60,000 and leave the remaining in the business. In other words, you’re deferring the taxes on the other $90,000 to a later point in time when you choose to take out the money. If your business wasn’t incorporated, you’d pay taxes on the full $150,000 immediately.
The second benefit is that you can take money out of the company is a more tax efficient manner (again, there are various things to consider so an accountant can better assist your personal situation). The two ways of taking money out of your incorporate business are salary or dividends. Salary falls into the personal income category, so you’ll owe income taxes and Canadian Pension Plan contributions. There are advantages to having some personal income, like creating RRSP contribution room, tax credits (medical expenses, child care, etc.) and paying into the Canadian Pension Plan.
Dividends are a different animal all together. First, they are taxed at a much lower rate of 17%. So, on that $60,000 if you took it all out as personal income, your real tax rate would be roughly 31.6% as opposed to 17% if taken out as a dividend.
Second, taxes on dividends are only calculated and paid when you file your personal income taxes each year in April. Your company will issue you a T5, which indicates to total amount of dividends paid to you as a shareholder of the company, this is recorded as income but taxed differently. Basically, if you take out $60,000 you actually get $60,000 in your bank account and will pay the 17% whenever you file your income taxes, so you could theoretically set aside the 17% and invest it until the time you need to pay your taxes. From a cash flow perspective having that money available to you is a fantastic benefit, as opposed to personal income taxes which are deducted and paid monthly on salary amounts.
Finally, the third benefit to dividends is dividend splitting. Let’s assume you have a family, your spouse doesn’t work or makes less than you do. In this case, you can split the dividends to reduce your overall tax implications. So, instead of paying your spouse a salary from the company, you can pay out via dividends to reduce your family’s overall tax implications.
Additional Things to Consider
While there are a number of benefits associated with incorporating, there’s also a multitude of tasks and costs associated with doing so. First and foremost, you will normally need a lawyer to actually incorporate a business which isn’t an inexpensive ordeal. Lawyers can cost anywhere between $2,000 to $5,000 to incorporate your company depending on the complexity required. Plus it’s a write off for your business.
Second, there’s many reporting requirements that you need to consider. The most notable is taxation, an unincorporated business results in the owner simply recording earnings as personal income and doesn’t require a different tax return. Corporations are required to file a separate return called a T2 in addition to completing a personal tax return. This means your bookkeeping needs to be more involved and you’ll require accounting software to make sure you account for it all. You also need to maintain multiple forms of paperwork like a minute book, up to date records of directors, share registries and articles (incorporation plus amendments). You’ll most likely want to engage an accountant to handle your taxes to ensure you maximize your tax savings, unless of course you plan to keep fully updated on Canadian tax rules…
To Incorporate or Not to Incorporate
Basically, it boils down to properly answering the three questions outlined above. The answer technically doesn’t have to be yes to each one either to make incorporation critical, for example you may not yet be earning what you need to live but the liability may necessitate that you incorporate. So, it’s technically not an easy to question to answer and one that can be different depending on your industry or earnings. There’s a multitude of factors to consider and I would highly suggest connecting with someone who can help you through the process of determining if incorporating is right for you and your business.
Get Started Now
Learn how one of our committed consultants can help you to immediately begin growing your business