I often get asked when is the best time for a business to incorporate.
The truth is there really isn’t a one-size-fits-all answer to this question. The decision will be as unique and individual as your business and what you decide will depend on your future plans and how you are performing.
The good news is that you are not stuck with the business structure you choose when you are starting out. This means that you can afford to be strategic about taking that next step and incorporating. Consider a business that is launched as a sole proprietorship. If the losses are high but risks low, it might make sense to keep that business structure. However, as those risks and profits grow, it might be time to consider incorporation.
Here’s some of the factors that encouraged my business partner and I to take the leap and incorporate.
Shrink your tax bill
When you incorporate, you may be able to do the following:
1. Choose when and how to take your income
Business tax rates are much lower than personal tax rates. If you are currently on a high income tax bracket, and can afford to do so, you can leave income in the business until your personal tax rate is lower.
You can also choose the most tax efficient way to pay yourself – whether that be salary, bonus, dividends or a combination of these.
2. Split your income
If you are on a higher tax rate, you can redistribute the company’s earnings to a spouse and/or child in a lower tax bracket.
3. Claim tax deductions as a small business
In Canada, certain small businesses may be eligible for a reduced tax rate for the first $500K of taxable income earned. This may reduce your net corporate business tax to a much lower tax rate than that applied to your personal income.
4. Claim capital gains exemptions
If your company is a Canadian Controlled Private Corporation, your capital gains could be tax free up to $750,000.
As attractive as these tax savings might seem, it is important to bear in mind that they might come at a cost. In addition to your personal tax return you will have to file a second annual tax return and foot the extra fees and hassle.
Another major disadvantage of incorporation is that losses will no longer be deductible from your personal income. And it goes without saying that corporations do not qualify for personal tax credits.
Incorporation may reduce your personal Liability
If you operate as a sole proprietor you will be personally liable for all of the debts of your business. If you incorporate, you generally will not be held responsible for the debts of your corporation.
There are limitations to this, though. Before rushing to incorporate you should think about whether you need bank financing and how easily you will be able to qualify for a bank loan. Lending institutions often ask for a personal guarantee to secure a loan where a corporation doesn’t meet their assets requirements. If you give a personal guarantee for a loan taken out by your corporation you will be personally liable for the debts of your business. This is why I tell clients with high losses and low liability to consider sticking with a sole proprietorship until their business grows.
Incorporating might make it easier for you to raise money so that you can grow your business. Corporations can raise money via equity financing – which is an option that isn’t available to you as a sole proprietorship or a partnership. As equity capital generally does not have to be repaid and incurs no interest this may offer you a number of advantages to grow and develop your company.
Of course, the flip side of this is that the more shares you issue in your company the less your personal stake in the ownership and control will be.
Here are some additional bonuses incorporating your business may bring:
1. Increased business
Did you know that some companies will only transact with incorporated companies because of liability and arms length issues?
2. Your business name will be protected
When you incorporate your business at the provincial or federal level, your business name will be protected. If you are a sole proprietorship or partnership and are not ready to incorporate, you should read my blog post on using trademarks to protect your business name.
3. Immortality (well, kind of)
If a shareholder dies or leaves the business the corporation will continue. In this sense a corporation has an unlimited life span that sole proprietorships and partnerships simply do not have. You can also sell a corporation more easily than a sole proprietorship. The flip side of this is that closing a corporation (dissolving and winding up) is going to be much more complicated!
What you can take away from this
Whether or not it is the right time for you to incorporate is going to depend on a number of factors. I recommend thinking through how each of the considerations I have listed above applies to your business, and keep track of how your priorities change as your business progresses and grows. If incorporation doesn’t make sense for your business right now – revisit in a year’s time.
Remember that incorporation can be expensive! Companies are complicated to set up and you can expect to pay at least a few hundred dollars in initial fees, on top of annual maintenance and accounting fees. Also remember that incorporating later in the life of your business might be more expensive, depending on how complicated it will be to transfer business assets over to the corporation, and to register your tax elections.
Finally, these considerations are complex. You might want to sit down with your accountant or business lawyer before deciding if incorporation is right for you.