Considerations for Incorporating Your Small Business
So first off, what the heck does it mean to incorporate your business, anyway? Well, at its core, incorporating means you are transferring your business into a new legal entity that is separate from you. In return for this, you receive shares of ownership in this new entity. You own it, but it’s not you. It’s its own ‘legal person’ that can enter into contracts, obtain debt, have its own bank accounts and credit cards – it can get sued and it can go bankrupt. All that fun stuff!
So why then would a small business owner want to incorporate? The two biggest reasons are for tax minimization and liability protection.
Incorporating for Tax Minimization
It’s important that you understand two key concepts in the tax minimization game. Tax deferral & tax avoidance.
Deferring tax means ‘putting off payment to some time in the future. It doesn’t get rid of the obligation, but here’s why savey tax minimizers like it: first off, if you don’t have to send tax money off to the government today, we can use that same money to work for us and hopefully create income or help finance your growing business. You can think of a deferral as the best interest free loan you could ever hope for, and in a weird way, it comes from the government. A dollar that we’re able to save today, is worth more than a dollar in the future.
Tax avoidance is when we can actually get out of paying tax all together. Yep, it exists. More on this later.
Deferring tax through a corporation
Now that you understand these two key concepts, let’s get into it! So, the # 1 reason by far for incorporating your small business is tax driven. And of course deferring and avoiding tax is the main reason folks incorporate their small businesses.
So how can we defer tax by incorporating? Think of it this way: here’s the difference between taxes for an incorporated company versus a sole-proprietor: as a sole-proprietor you earn revenue, you deduct business expenses to get the net income of the business and you report 100% of that income on your personal tax return. You will pay taxes at whatever tax-bracket the income falls under, regardless of the amount you’ve actually drawn from the business. Now this isn’t a big deal if you’re drawing out everything you’re bringing in, but what if your business is making more money than you actually need to fund your personal expenses? I know this may not seem like a problem they’ll ever get to, but when it does, ask yourself this: ‘Doesn’t it suck that even though I don’t need the money, right now, that my small business has generated, I have to send away a bunch of tax to the government?’ Well what’s the alternative? Incorporate!
Here’s how tax works for incorporated business owners: the company generates revenue and deducts business expenses to get a net income that it pays corporate taxes on that is significantly lower than the personal tax rates at certain higher levels. The owner will make up the difference when she draws out the income she needs to fund her personal expenses – so, at this point, there’s no real benefit to earning the money personally vs corporately yet, and here’s where it gets really sexy, the money she didn’t need to draw out only incurred a relatively low tax rate. The after-tax money can sit in the company in a tax deferred manner. That money can be used to grow the small business or can be put to work in other ways. So, in a nutshell, if your business is making more money than you need to live, time to go see your accountant!!
Avoiding tax using a corporation
How can we actually avoid tax by incorporating? There are a couple ways.
1. The capital gains exemption.
This is a lifetime exemption that is available to every Canadian resident who sells shares in a qualified small business corporation but in a nutshell, this exemption can be used to reduce the capital gain on the eventual sale of those shares. This is a substantial exemption – we’re talking a celebration of epic proportions if you’re able to take advantage!
2. Stage of life influences.
Tax deferral can sometimes turn into tax avoidance. Remember those excess assets that your company was producing that you didn’t need to fund personal expenditures? Well someday, depending on a whole bunch of variables, you may find yourself in a lower tax bracket than you were during your productive career. Think about it, when we’re younger we have mortgage payments, diapers, formula, day care, teenagers, huge grocery bills, and then university, not to mention all the toys and trips you may have spent money on along the way. But, when we retire, a lot of those expenses are eliminated or reduced. Our financial needs are generally not as demanding as the earlier years. We start to eat like birds, therefore, when we draw down on the savings we accumulated in our corporate structures, we are possibly doing so in a lower tax bracket. Its not always the case, but we definitely get more flexibility and more control around our tax situation within the incorporated world.
There are some other things we can manage with incorporation, such re-purposing funds away from the Canada Pension Plan into our investment plans.
Incorporating for Liability Protection
Incorporating your business can bring an element of protection to the business owner in the event that its business suffers a financial blow so hard that it can’t recover, such as damages arising from a civil lawsuit or bankruptcy. Business owners can find incorporation as an attractive way to protect their personal assets, such as their houses and personal savings. Remember, while the small business owner may be the owner of the company, there is a legal separation between her and her company. While this all sounds like good disaster planning, here’s the thing: most business owners should weigh the benefits and costs of this before making a decision to incorporate solely on their desire to protect themselves. Remember, you’re gonna want to insure your business against liability anyway and in some cases, you can get policies underwritten for one to two million dollars in most run-of-the-mill businesses. You may want to ask yourself how litigious your industry is. Remember, it costs money to incorporate – like thousands if you do it right – and there’s annual administration costs as well, so make sure you don’t jump too quickly into this and bring a gun to a knife fight.
The other thing to consider when contemplating your risk threshold is this: if your small business corporation ever requires bank financing, most banks are going to require the corporate small business owner to sign a personal guarantee anyways, which puts the owner on-the-hook personally in the event their business becomes insolvent. This is pretty normal for business owners to sign these – hey, small business ownership is not for the faint hearted!
Question: Do I get credit for all the capital assets & inventory, etc. that I purchased as a sole-proprietor that will be rolled into the company?
Answer: Hell yes! You get full credit.
Question: What about outstanding business loans: do they get rolled into the company?
Answer: Possibly and preferably yes. But, this is something that needs to be communicated and managed between you, your CPA, lawyer and creditor. Sometimes newly incorporated small businesses can have a hard time getting access to credit, right out of the gate – not always, but sometimes. It’s not the end of the world, because you can continue to use credit cards or lines of credit that you had personally, and your CPA will just make sure the proper accounting happens for these scenarios.
Question: Are there are additional expenses that can or cannot be claimed as a corporation versus sole-proprietorship?
Answer: For the most part, really not much changes in this regard. It’s important to keep a good set of books – maybe even a little important, but all the rules that apply to a sole-proprietor versus an incorporated business are the same.
Question: What are the initial set-up and annual costs for incorporating?
Answer: Set-up fees can get into the thousands of dollars and will include accountant and lawyer fees. Your annual costs for tax preparation are going to be more than a sole-proprietorship, because there is a fair bit more administrative and compliance work that is required with a corporation in your life. Remember, a good CPA will crunch the numbers and make sure that going forward with an incorporation is a good investment depending on the specifics of your scenarios. Never try to do this yourself to save a buck! Incorporating an existing business is a highly complex & delicate process that requires careful coordination with your lawyer on the steps for setting the company. Furthermore, there are protective clauses and filings that a CPA will make sure are in place to avoid any surprise tax bills down the road.
Question: Who manages this process?
Answer: A CPA well-versed in the public accounting industry should lead this process. Good lawyers often will not proceed without instruction from a CPA firm. However, sometimes lawyers, not as experienced with corporate work like this will go ahead and incorporate a client without a CPA in the mix. This can be just as dangerous as doing it yourself, so be careful and when in doubt, make sure you have a good CPA in your life that helps you through these big milestones.
Like we always say, keep your friends close, but your accountant closer! Want to chat more? CLICK HERE to book a call or Zoom.
- It’s important that a CPA is involved if you want to put the money to work in ways other than re-investing back into your business. Things such as rental properties, portfolio of investments or even just leaving it in the bank account can cause possible problems down the road. Your CPA will likely have a bit more of an elaborate structure they will want in place if these passive type assets get on the higher side. ↑
- The details of what qualifies small business shares for the capital gains exemption should be discussed with your CPA. These rules are very complex. ↑