Should You Incorporate Your Small Business?

Look at Both the Advantages & Disadvantages Before You Decide

Should you Incorporate your Business?. Image (c) Sam Edwards / Getty Images

Every small business person considers whether or not to incorporate his business at some point. The form of business ownership isn't fixed forever; you can change the legal structure of your business as it grows. A common scenario is for small businesses to start out as sole proprietorships or partnerships and become incorporated at some later date when the business has grown.

(See How to Incorporate Your Business in Canada for information on the process of incorporation.)

But is incorporation a wise move for your small business?

Advantages of Incorporating

1. Limited Liability

The main advantage to incorporating is the limited liability of the incorporated company. Unlike the sole proprietorship, where the business owner assumes all the liability of the company, when a business becomes incorporated, an individual shareholder's liability is limited to the amount he or she has invested in the company.

If you're a sole proprietor, your personal assets, such as your house and car can be seized to pay the debts of your business; as a shareholder in a corporation, you can't be held responsible for the debts of the corporation unless you've given a personal guarantee.

On the other hand, a corporation has the same rights as an individual; a corporation can own property, carry on business, incur liabilities and sue or be sued.

For information on business liability insurance see Home-Based Business Insurance.

2. Corporations Carry On

Another advantage of incorporating is continuance. Unlike a sole proprietorship, a corporation has an unlimited life span; the corporation will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes.

Selling a corporation is more straightforward than attempting to sell a sole proprietorship.

 

3. Raising Money Is Easier

Corporations also have more ability to raise money, which may make it easier for your business to grow and develop. While corporations can borrow and incur debt like any sole proprietorship, they can also raise money by equity financing, which involves selling shares in the corporation to angel investors or venture capitalists. Equity financing is advantageous in that equity capital generally does not have to be repaid and incurs no interest. (Of course, by issuing shares, you are reducing your percentage of ownership in the company.) 

For information on small business financing in Canada see 10 Things You Need to Know About Small Business Funding and 5 Creative Ways to Raise Money for Your Business.

4. Income Control

If you incorporate your small business, you can determine when you personally receive income, a real tax advantage. Instead of getting your income when it's received, being incorporated allows you to take your income at a time when you'll pay less in tax.

5. Potential Tax Deferral

Becoming incorporated gives you tax deferral potential. Because you can defer paying some tax until a later time, you may be able to realize tax savings if you are then in a lower tax bracket, or if the tax rates have fallen.

6. Income Splitting

Another tax advantage of incorporating is income splitting. Corporations pay dividends to their shareholders from the company's earnings. A shareholder does not have to be actively involved in the corporation's business activities to receive dividends. Your spouse and/or your children could be shareholders in your corporation, giving you the opportunity to redistribute income from family members in higher tax brackets to family members with lower incomes that are taxed at a lower rate.

See Salary or Dividends - How Do I Pay Myself? and Pay Less Income Tax With Income Splitting.

7. The Small Business Tax Deduction

If you incorporate your business, it may qualify for the federal small business deduction (SBD). The SBD is calculated at the rate of 10.5% on the first $500,000 of taxable income, which may reduce your net corporate business tax to a much lower tax rate than that applied to your personal income.

8. Increased Business?

Having Ltd., Inc., Ltee., or Corp. as part of your company's name may increase your business, as people perceive corporations as being more stable than unincorporated businesses. If you're a contractor, you may also find that some companies will only do business with incorporated companies, because of liability issues.

9. Business Name Protection

When you incorporate your business provincially, the business name you choose is reserved for your use in that province, or if you incorporate your business federally, you have the right to use your business name throughout Canada. Sole proprietorships and partnerships have absolutely no business name protection. If your business is not incorporated, anyone can start a business with the same or a similar name if they wish. 

Incorporating your small business sounds like a great idea, doesn't it? But there are also disadvantages that you need to consider. 

Disadvantages of Incorporating

1. Another Tax Return

When you incorporate your small business, you'll have to file two tax returns each year, one for your personal income and one for the corporation. This, of course, will mean increased accounting fees. Unlike a sole proprietorship or partnership, corporate losses can't be deducted from the personal income of the owner.

2. Increased Paperwork

There is a lot more paperwork involved in maintaining a corporation than a sole proprietorship or partnership. Corporations, for example, must maintain a minute book containing the corporate bylaws and minutes from corporate meetings. Other corporate documents, that must be kept up to date at all times, include the register of directors, the share register and the transfer register. (See Getting Your New Corporation Up and Running for more information.)

3. No Personal Tax Credits

Another disadvantage of incorporating is that being incorporated may actually be a tax disadvantage for your business. Corporations are not eligible for personal tax credits. Every dollar a corporation earned is taxed. As a sole proprietor, you may be able to claim tax credits a corporation could not.

4. Less Tax Flexibility

A corporation doesn't have the same flexibility in handling business losses as a sole proprietorship or a partnership. As a sole proprietor, if your business experiences operating losses, you could use the loss to reduce other types of personal income in the year the losses occur. See 8 Tax strategies to Maximize Your Business Tax Deductions. In a corporation, however, these losses can only be carried forward or back to reduce the corporation's income from other years.

5. Liability May Not Be as Limited as You Think

The prime advantage of incorporating, limited liability, may be undercut by personal guarantees and/or credit agreements. The corporation's much vaunted limited liability is irrelevant if no one will give the corporation credit.

When a corporation has what lending institutions consider to be insufficient assets to secure debt financing, they often insist on personal guarantees from the business owner(s). So although technically the corporation has limited liability, the owner still ends up being personally liable if the corporation can't meet its repayment obligations.

6. Registering a Corporation is Expensive

A further disadvantage of incorporating is that corporations are more expensive to set up. A corporation is a more complex legal structure than a sole proprietorship or partnership, so it's logical that creating one would be more complicated and costly.

Fees for incorporating a small business either provincially or federally range in the hundreds of dollars - and that's just for the set up. I've already mentioned the increased maintenance and related fees, such as increased accounting costs.

7. Closing a Corporation is More Difficult

Closing a corporation requires passing a resolution to dissolve the corporation, winding up payroll accounts, and sending a copy of the Articles of Dissolution to the Canada Revenue Agency along with the final tax return for the corporation.  See Closing Your Business for more information.

So Should You Incorporate Your Small Business?

Maybe.

You should definitely discuss your personal situation with your accountant and lawyer before you decide. He or she will be able to give you a much more exact picture of how incorporation could benefit your business, and help you see whether or not the trouble and expense of incorporation will be worth it to you.

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