Friday, January 24, 2014

Consultants and small businesses: When is it time to incorporate your business?

For most businesses, the question is not if, but when, to incorporate.  There are many pros and cons of incorporating a small business, depending a lot on individual situations.  But too many businesses fail to revisit the question of whether to incorporate.  As your business matures, and the realities of your legal and tax situations change, asking the question again may bring a different answer

The pros and cons of incorporating a small business can vary, but here are the most common:


1.       Limited liability: Your business is a separate legal entity and as such, creditors or legal actions go against your corporation and its assets, not your personal assets. (There are exceptions, such as personally guaranteed loans, government tax obligations and payroll deductions, among others.)

2.       Tax efficiency: You can choose the most tax-efficient way to pay yourself, including dividends, salary, bonus or a combination. You can even use dividends as a way to split income with your spouse if he or she is a shareholder in your Canadian Controlled Private Corporation.

·         As a sole proprietor (not incorporated), one must be careful when “income splitting” to other family members via salary or “fees paid” in a sole proprietorship. The question to ask oneself is, “what would l pay an arm’s length party to do this work they are doing?” In most cases, this would involve minimal amounts of income. With a sole-proprietorship, one is limited to income splitting to other family members via “salary or fees paid” to other family member(s).

·         With a corporation one can legally and acceptably income split with other family members via “dividends”, which is not based upon a “value for service rendered” concept; rather the payment of dividends, and thus access to income splitting, is based upon share ownership in the corporation. Therefore, the corporate model provides access to income-split much larger amounts than you would be able to income split via a sole proprietorship. Acceptable income splitting can be accomplished with other family members when a corporation is utilized, as the flexibility to income split via dividends to these family members is available and thus is applied to their lower personal tax brackets.

3.       As a sole-proprietorship, you are limited to setting December 31st as the year end of the business. An incorporated entity can set a year end at any time during the year.  This provides the flexibility to minimize overall income taxes, by allocating corporate income, which has a year -end that straddles December 31st, to two tax years of an individual shareholder, and his family members, who file their tax returns on a calendar year basis. This provides the ability to keep overall income in the lower tax brackets and thus pay less tax on the same income.

4.       If you don’t need all business earnings for personal income, you can leave them in the business, deferring personal taxes on withdrawals and possibly enjoying an approximately 15-per-cent preferred tax assessment on the first $500,000 of profit in CCPCs.


1.       Incorporating costs money. You can do it on your own, technically, but it’s more advisable to get the help of a lawyer and an accountant.

2.       Incorporated entities must file more paperwork, such as separate tax returns, an annual return, one-time articles of incorporation and notifications of share sales, moves or changes of directors.

3.       Losses in an incorporated company can’t be personally claimed. A failed start-up can only be “written off” personally to the amount you had invested, not the accumulated negative earnings.

As for the accounting side, as long as you remain a sole proprietorship, all your profits will be taxed as personal income, which could involve tax rates potentially as high as 46 per cent. If you have a small business, earning, say, $60,000 or so, you may be fine either way. Once, however, you start earning well above that level, you may be missing out on ways to more effectively manage your taxes: income splitting with family members and/or deferring income taxes, for example.

A business with anticipated losses and little legal risk can likely start as a sole proprietorship, but increasing risk and more significant earnings will favour incorporating later on.

In general, if you are committed to a career as an independent consultant, incorporation is recommended, but you should seek professional accounting and legal advice specific to your circumstances.

So when should your business incorporate?   Keep asking that question until you grow into a different answer, and then you can quickly take action.

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