When Should You Incorporate Your Business?

Tax Deferral

One of the most significant potential benefits of incorporation is the ability to defer personal income tax by leaving some business profits inside the corporation.

In BC, an eligible Canadian-controlled private corporation can generally access a combined federal and provincial small business tax rate of approximately 11% on the first $500,000 of qualifying active business income.

For example, if a corporation earns $500,000 of net active business income, approximately $55,000 of corporate income tax would be payable, leaving $445,000 after-tax profit in the corporation.

By comparison, if the same $500,000 of business income were earned personally through a sole proprietorship, the owner’s personal income tax bill would be substantially higher – as much as $220,000 or more on the same level of income.

Note, however, that utilizing a corporation doesn’t make the personal tax component disappear. When money is eventually withdrawn from the corporation by its shareholders, a layer of personal tax will then apply. The benefit is that the shareholder has more control over when that money is withdrawn and, therefore, has some flexibility as to the timing and amount of personal tax incurred.

This can be particularly valuable for business owners who do not need to spend all of their business profits personally each year. If you earn $250,000 but need to withdraw nearly all of it personally to fund your lifestyle, the tax-deferral benefit of incorporation will be much smaller.

On the other hand, if your business earns $250,000 and you only need $100,000 personally to fund your lifestyle, the ability to leave the remaining $150,000 to grow or invest in the corporation provides a significant tax-deferral opportunity. This leads to the next benefit:

Income Smoothing

For a sole proprietor, the business’s taxable profit is reported personally in the year it is earned. This means that a particularly strong year can push a significant portion of your income into the highest personal tax brackets.

A corporation can provide more flexibility because business profits can remain in the corporation and be withdrawn in future years.

Consider a business owner whose income fluctuates significantly from year to year. For example:

• Year 1: $300,000 of business profit
• Year 2: $50,000 of business profit

Rather than necessarily taking the full $300,000 as personal income in year 1, the business owner may be able to leave some of the after-tax corporate profits in the corporation and withdraw additional amounts in year 2.  As an example, if the shareholder draws out $175,000 in year 1 and another $175,000 in year 2, they will still have drawn out all $350,000 net profit, but will have paid significantly less personal tax than if they were a proprietorship reporting $300,000 of income in year 1 and $50,000 in year 2. This is because across the two taxation years, they will have a much lower effective marginal tax rate.

Income smoothing can be particularly relevant for businesses with cyclical or unpredictable income, such as real estate agents, commission-based businesses, consultants and other businesses where income can vary substantially from one year to the next.

Potential Tax Planning Opportunities

A corporation can also provide access to tax planning strategies that generally aren’t available to a sole proprietor.

Depending on the circumstances, these can include strategies involving:

• Different streams of shareholder remuneration (salaries vs. dividends).
• Ability to avoid paying into the Canada Pension Plan (CPP), which can free up over $9,000 in cash flow annually per active shareholder.
• Corporate retirement and investment planning.
• Estate and succession planning.
• Ability to use the lifetime capital gains exemption on the sale of a business, when certain criteria are met. This exemption can result in over $1.25M of capital gains being virtually tax-free on a qualifying share sale.
• Bringing family members into the ownership of a business, where appropriate.

Additional Asset Protection

A corporation is a separate legal entity from its shareholders. This can provide an additional layer of protection for your personal assets if the business faces a lawsuit or creditor claim.

Generally, when a business operates through a corporation, the corporation is responsible for its own debts and obligations. A shareholder’s personal assets (home, investment accounts, savings, etc.) can be protected from claims that arise against the corporation. This is different from a proprietorship, where there is no separation between the business and the taxpayer.

There are important exceptions, however. For example, personal guarantees provided for corporate loans, leases or other obligations can create personal liability. Shareholders may also be personally liable in certain circumstances, including for their own negligence or malpractice, or where specific statutory liabilities apply.

Incorporation should therefore not be viewed as an absolute shield against personal liability, but it can provide an important additional layer of protection over your personal assets.

Financing and Future Growth

Incorporation can also make sense when a business is moving from a small owner-operated business toward a larger enterprise.

A corporation can make it easier to:

• Bring in additional shareholders or investors
• Structure the purchase or sale of a business
• Transition the business to the next generation

For example, if you expect to eventually bring partners into the business, sell a portion of the business, or sell the entire business, establishing a corporate structure early can provide additional planning opportunities.

So, When Should You Incorporate?

There is no magic income threshold at which incorporation suddenly becomes the right answer.

Instead, consider incorporating when one or more of the following apply:

• Your business is generating more profit than you need to withdraw personally.
• Your income fluctuates significantly from year to year.
• Your business has meaningful liability or creditor risk, and you want to protect your personal assets.
• You expect the business to grow significantly.
• You want to retain profits to fund future investments or expansion.
• You are considering bringing in a business partner.
• You are beginning to think about succession or eventually selling the business.
• You already earn employment or investment income and want to operate a side business without adding that business profit to your existing personal income sources.
• The potential tax and planning benefits outweigh the additional accounting, legal and administrative costs of maintaining a corporation.

For some business owners, incorporation can make sense relatively early, or even from the initial start up. For others, remaining a sole proprietor may be simpler and less costly to maintain.

The important point is not simply how much revenue your business generates—it is how much profit you earn, how much you need personally, the risks you face and where you want the business to go.

If you’re wondering whether incorporation makes sense for your business, we can help you compare the tax, legal and administrative implications of both structures before you make the decision.