Businesses can take many different legal forms. Which one is right for yours?
You started a business, you’re earning revenue, things seem to be going well, and everything is exciting. Your friends and colleagues tell you that you should incorporate to save tax and add legitimacy to your business.
In this article, we’ll look at the differences between business structures and discuss the advantages and disadvantages of using a corporation, sole proprietorship, or partnership. By the end, you should be able to decide when to incorporate your small business. But before diving into which business structure is right for you, it’s important to review the features of each type so you know what’s available.
What is a Sole Proprietorship?
With this business structure, the entrepreneur is the business. It is the most common type of small business because there is no requirement to register the business with the government (notwithstanding the GST/HST rules and payroll accounts), and proprietors can use their own name in the business (or register a “trade name” if they wish). The legal and accounting costs of maintaining the business are minimal compared to a corporation, which is why entrepreneurs often choose this structure, particularly in the startup phase. There is no separation of legal liability between the entrepreneur and the business, and entrepreneurs report their businesses’ income and expenses on their personal tax returns using Form T2125 Statement of Business or Professional Activities. Entrepreneurs in Canada are only expected to submit business income statements (not their balance sheets), making accounting and tax easier for sole proprietorships than for corporations.
What is a Corporation?
A corporation is a separate legal person in the eyes of the law. It has its own ‘birth’ (incorporation), ‘death’ (windup), rules for life (bylaws and articles of incorporation), credit score, and ability to enter into legal agreements. It can lease, buy, hold, and sell property independent of its owners. A corporation is owned by shareholders, and those shareholders’ liabilities are generally limited to their investment in the corporation. Corporations are assumed to ‘live’ forever, which is one of the reasons to use this structure—it will survive its shareholders over multiple generations. The legal and accounting costs of maintaining a corporation are higher than a sole proprietorship because the legal and tax obligations are more involved (and onerous). Corporations in Canada are obliged to prepare and file their own tax returns (T2 Corporate Income Tax Return), which are more complicated than T2125s filed by a proprietor because corporations must submit both an income statement and a balance sheet (amongst many other additional filings and reporting obligations).
What is a Partnership?
A partnership is an agreement between two or more parties (corporations, sole proprietors, or a combination) to be in business together. The agreement doesn’t need to be written (although we always recommend agreements be formalized in writing), thus it is quite easy to enter and exit a partnership. Since partnerships are simply agreements and not separate legal entities, the partners (corporations and/or sole proprietors) carry the liability of the partnership’s operations. Partnerships do not pay income tax in Canada. Instead, the partners are required to report their share of the partnership’s income on their tax returns. Partnerships can, however, employ people, enter into legal agreements, and hold loans and mortgages on behalf of their partners, and collect and remit GST/HST. Partnerships are generally required to prepare information returns and slips to advise partners about their share of the partnership’s income (Form T5013 Statement of Partnership Income).
What is a Joint Venture?
A joint venture is also an agreement for two parties (the venturers) to be in business together; however, the scope of the venture agreement is generally limited to a project rather than an entire business. For this reason, the venturers typically handle things like bank accounts, payroll accounts, GST/HST, and the like because the venture is not a ‘business’ (like a partnership), but rather an agreement to work on a project (a venture) together.
Should I incorporation my business? Advantages and Disadvantages?
“Should I incorporate” is one of the most frequently asked questions we get asked as accountants. The answer is, quite simply, “it depends.” In this section, we discuss the most common considerations when deciding if a small business should incorporate. We’ll also dispel some common myths about corporations.
How much does it cost to maintain a corporation?
The legal, accounting, and other professional costs of maintaining a corporation are substantially higher than maintaining a sole proprietorship. This is because a corporation is a separate legal entity with its own set of legal and tax obligations that typically require the expertise of professionals (lawyers and accountants) to maintain. As an example, a personal tax return for a proprietorship starts at ~$500, where a corporation’s yearend (including T2 tax return) starts at ~$2,750. This is due to the increased complexity in preparing the businesses’ balance sheet and tax filings.
Business owners should expect to pay at least $4,000 – $5,000 per year to maintain a corporation. Many entrepreneurs are surprised when they learn about this when their first corporate tax return comes due. This can be a substantial cost for startups so careful consideration should be given as to whether a corporation is required or if a sole proprietorship will suffice. It is possible to change a sole proprietorship to a corporation after the business is established and has the funds to pay the additional maintenance costs. (It can be much more complicated and costly to change a corporation to a sole proprietorship.)
Are there tax benefits to incorporating?
It is possible to save taxes by using a corporation compared to reporting income as a sole proprietor on your personal tax return, but not for the reasons you might think. For the most part, the tax deductions a corporation can claim are the same as those that a sole proprietor can claim. The difference lies in the tax rates and how the profits of the business are used.
Business income is subject to the individual, marginal tax rates of the sole proprietor, which can range from 15% to 48% (AB – 2020). Once the income is earned, the sole proprietor is free to use the funds for any purpose, including paying personal expenses.
A Canadian Controlled Private Corporation pays 11% tax (AB – 2020) on ‘active’ taxable income up to $500,000, and 23% thereafter. Once income is earned, the corporation is free to use those funds to re-invest in the business, pay expenses (like salaries), pay off debt, and/or pay dividends to its shareholders. A shareholder that relies on the company’s income to pay personal expenses must pay personal tax on the cash received in the form of salaries or dividends from the corporation (see our analysis of salaries vs. dividends here).
There is a concept in Canada’s tax system called ‘integration.’ This is the idea that a dollar earned in a corporation and then paid to a shareholder (via a salary or dividend) will result in the same amount of tax being paid as if the shareholder had earned that same dollar through a sole proprietorship. When the net income of a business is fully distributed to its owners, the tax system is indifferent to the company’s structure.
If all the net income earned in a corporation is paid out to the shareholder(s) of the corporation, there is no tax advantage to having a corporation. If a corporation earns more net income than the shareholders of the corporation require to fund personal living expenses, there is a tax-saving opportunity as the excess can be retained in the corporation, at a lower tax rate, for future growth and investment. Of course, the excess will be taxed at normal rates eventually when distributed to shareholders in the future, although tax planning can minimize the tax paid under this scenario.
Thus, to decide if a business should be incorporated for tax purposes, the owner(s) needs to determine if there is an opportunity to leave earnings behind in the company to reinvest, or if all the income will be paid out to the shareholders to fund personal expenses. The latter makes a corporation unnecessary for tax purposes.
Does a corporation add credibility to my business?
Many business owners believe that having a corporation adds credibility to their business; owning a corporation is seen as ‘cool’ or necessary. This is mostly an emotional, or egoic, impulse rather than a factual one. We’ve never come across a scenario where a small business has greater credibility strictly because its name has “Ltd.” or “Inc.” at the end of it. As mentioned above, a sole proprietorship can register the same trade name that it might have chosen as a corporation for branding purposes.
A corporation may, however, be required in scenarios where the owner does not want to be ‘front and centre,’ or where being front and centre harms the company’s credibility in the market or with vendors. In fact, certain vendors will only deal with incorporated entities for a variety of reasons, including liability and in certain subcontract arrangements. Such circumstances are rare amongst small businesses and are largely industry-specific. Other credibility issues are better covered in the ‘legal liability’ and ‘certain sub-contract arrangements’ section of this article.
To decide if a business should be incorporated for credibility purposes, the owner(s) needs to prepare an honest assessment of the risks of using a tradename vs. a corporation, including market analysis and analysis of vendor relationships.
Does a corporation protect me from liability?
In a sole proprietorship, the owner is personally liable for the liabilities of the business because they are one and the same with the business. This may not be ideal in certain situations where there are inherent risks of liability that exceed a businesses’ insurance coverage. In most cases, it is not possible in a sole proprietorship to separate a business owner’s main assets (house, buildings, investments, etc.) from the liabilities inherent in the operations of the business—increasing the entrepreneur’s liability exposure.
Because a corporation is a separate legal person in the eyes of the law, it can own its own assets and is exposed to its own liabilities. The shareholders of the corporation are generally only exposed to these liabilities to the extent of their investment in the business. Thus, corporations can be used to create a layer of liability protection between the shareholders of the company and the operations of the company*. A corporate structure comprised of more than one corporation can be used to separate the main assets of the corporate group (land, building, machinery, investments, life insurance, etc.) from the operations of the operating company.
To decide if a business should be incorporated for liability purposes, it is important for the entrepreneur to understand the liability exposures inherent in the business, which usually requires consulting a lawyer. After the risks are understood, entrepreneurs should consult a lawyer and insurance adviser to see if the risks can be mitigated, and if a corporation is required.
*Note: In small businesses, shareholders of the corporation are also often the directors of the corporation. Certain liabilities exist for corporate directors and we recommend consulting a lawyer about these liabilities.
Why am I being asked to incorporate a company in order to accept a job as a subcontractor?
There are certain circumstances when it is more appropriate for companies to hire sub-contractors rather than employees. This is typically when the company wants to hire someone for a limited engagement as a full employment relationship may not be warranted. As noted in our article “employees vs. subcontractors,” the line between an employee and a sub-contractor can be razor thin, and regardless of what the contract says, the CRA may determine that a sub-contractor is, in fact, an employee, creating negative implications for the company.
To avoid these implications, some companies will only sub-contract to a corporation because it is legally impossible for a corporation to be an employee. This forces the would-be subcontractor to incorporate a company to take the job and, as noted in the article linked above, it pushes issues associated with being an employee away from the company and down to the sub-contractor.
We have often dealt with business owners who were forced to incorporate to accept a job; most of them are surprised that this adds several thousand dollars per year in professional costs. Nearly all are surprised to learn that they still need to pay hefty annual professional fees to maintain their corporation even after the job ends. In certain circumstances, the corporation can be wound up easily to ‘stop the bleeding;’ however, if the owner has accumulated assets in the corporation (investments, cash, etc.) there can be adverse and unexpected tax consequences to a windup. To avoid those consequences, they are forced to pay several thousand dollars a year to maintain an otherwise dormant corporation indefinitely.
To decide if a business should be incorporated for certain sub-contract arrangements, the owner needs to analyze the ongoing lifetime costs of maintaining a corporation vs. the benefits of accepting a job that requires them to incorporate compared to other opportunities in the market, such as becoming an employee.
I need debt!
Are you buying a business? Need cash to fund an expansion or a new piece of machinery? Then you may want to incorporate a company. Principle payments on debts are not deductible for tax, which means debts are repaid with after tax earnings. If an individual (a proprietorship) borrows $100k, and they are taxed at the top marginal tax rate (48% – AB 2021), they need to earn $192,309 in net income in order to pay back the debt. A Canadian Controlled Private Corporation only needs to earn $112,360, $79,949 less than the individual (proprietorship).
Get Expert Advice & Follow It
Talk to a tax specialist to ensure that the proper structure is in place for your business. If you would like to discuss this with us further, please reach out — we love chatting with entrepreneurs and we’d love to hear your story.