Whether (and when) to incorporate a business is a question that many business owners and professionals are faced with as they begin to see success. This is a complex decision with tax, legal, and financial implications. Here are some of the most important things you and your advisors should be thinking about when it comes to incorporation in Canada.
Corporations are legal entities that exist separate and distinct from their shareholders. Many businesses are structured as corporations, but incorporation is not generally a requirement to carry on a business.
A sole proprietorship or partnership structure is the typical set up for the early stages of building a business or professional practice. For tax and legal purposes, you do not segregate your personal and business assets, and you do not file a separate tax return; you are one with the business. The set up and ongoing maintenance costs for this approach are minimal, and your business income and losses are treated as your personal income and losses. This is the default approach for business owners.
A corporation is a separate legal entity, which has both advantages and disadvantages. A corporation can enter into contracts, own assets, and earn income separately from its owners. Multiple people can own shares in a corporation, and these shares can be bought and sold without affecting the existence of the corporation.
By nature of being a separate legal entity, corporations have some distinct benefits as a business structure.
In Canada, the tax rates on active business income in a corporation are favorable compared to personal tax rates. This is also true, in some cases, on passive investment income inside a corporation. Generally, these lower corporate tax rates result in a deferral of tax rather than a tax savings since the shareholder will ultimately need to pay personal tax to extract assets from the corporation, but this deferral of personal tax can be a powerful planning tool.
Whereas a sole proprietor will need to realize all of their net income personally each year, potentially paying personal tax at the top marginal rate (53.53% in Ontario in 2023), a corporation allows for the flexibility to distribute salary or dividends as needed to fund lifestyle costs, while leaving all remaining net income inside of the corporation to accrue at much lower tax rates. The tax deferral is particularly effective for small businesses with active business income up to $500,000 annually. These corporations enjoy markedly low tax rates on their net income.
Long-term, one of the greatest advantages of the personal tax deferral is the ability to control when personal income is realized. If a successful business owner is at the peak of their career with an income that puts them at the top marginal tax rate, every additional dollar withdrawn from the corporation will result in significant personal taxes owning. They can instead choose to defer that personal income to later in life when their business has slowed down and they are able to use their lower marginal tax rates to efficiently extract income from the corporation.
The Lifetime Capital Gains Exemption (LCGE) is an exemption from tax on net capital gains realized from selling shares of a qualified small business corporation. For dispositions in 2023, the LCGE is $971,190. These are large numbers so it’s worth understanding the implications. While the LCGE is less interesting for businesses that are not saleable, if you decide to sell a business you’ve spent your working life building, there are tax implications to this.
Let’s imagine a successful business that has been built from the ground up to become a revenue generating machine. An interested buyer is willing to pay $950,000 for this business. If this were set up as a sole proprietorship, the owner will pay around $250,000 in tax on the sale (assuming the top tax rate in Ontario in 2023).
If they are instead set up as a Canadian Controlled Private Corporation (CCPC) they will be exempt from tax on this transaction – a $250,000 tax savings. Meeting the requirements for the LCGE takes some planning in advance of the ultimate transaction, but as a tax planning tool it is hard to beat.
An Individual Pension Plan (IPP) is a type of defined benefit pension where the employer (i.e. the corporation) makes contributions each year to secure a future annual retirement income for the employee (i.e. the owner). IPPs allow for significantly higher annual contribution room than RRSPs for people above the age of 45, and this advantage just increases with age. To set up an IPP, there must be a sponsoring corporation from which the business owner and plan member has been withdrawing T4 salary income. Dividend income will not qualify for IPP contribution purposes.
Contributions to an IPP are tax deductible to the corporation, and like an RRSP all growth within the IPP is tax-sheltered. Beyond regular annual contributions, business owners have additional opportunities to fund the IPP at the time it is set up, and again at retirement. The IPP is certainly not a homerun across the board, but for some business owners it can have a meaningful long-term benefit.
In any case, IPPs are only available to shareholders of corporations.
As a separate legal entity, a corporation can exist beyond the lives of its shareholders. This alone allows for more flexibility and planning opportunities for a long-term business than a sole proprietorship. There are other advantages too.
A corporation can reduce probate. Probate is a process by which the courts confirm a deceased person’s Will to be his/her valid Last Will and Testament, and validate the authority of the executor. Probate fees in Ontario are 1.5% on the value of the deceased’s estate that exceeds $50,000. On a large estate, these fees can be substantial. If a business owner has accumulated assets personally and is operating as a sole proprietor, their estate will pay these fees. Alternatively, a business owner can have dual Wills; one Will for private corporation shares that do not require a grant of probate, and one Will for other personal assets. Dual Will planning has the added benefit of privacy, since a probated Will is a matter of public record.
Finally, a corporation can play a role in estate freeze, where the tax liability at a point in time can be “frozen” in the hands of one group of shareholders while all future tax liabilities accrue to another group of shareholders. This type of tax planning may is often useful as part of a tax-efficient multi-generational business or wealth transfer.
Optimism is a requirement for every business, but the reality is that not all businesses will be successful.
A sole proprietorship has unlimited personal liability – you are one with the business, remember? Your business risk and your personal risk are one and the same. In the event of a loan default, the business owner’s personal assets can be seized to pay the liabilities of the business: your home, bank accounts, and retirement savings alike.
The way to legally separate a business from a business owner’s personal assets is to incorporate. This creates limited liability, or a corporate veil, around the company’s shareholders. In the absence of personal guarantees, the liability of the business does not extend beyond the corporation’s assets. This protects the shareholder from corporate debt defaults and potential litigation against the corporation.
For a business that intends to raise capital from outside investors, a sole proprietorship will find more challenges than would a corporation. The life of an individual is finite, making it harder for others to invest in a sole proprietorship.
On the other hand, a corporation’s existence is independent from any individual business owner’s lifetime. It is a separate legal entity that can sell equity shares or debt in the business to outside investors. Incorporating can also provide a dose of credibility to outsiders.
There are up front and ongoing costs related to the tax and legal compliance of incorporation: the drafting of a shareholder registry, articles of incorporation, and the filing of a separate annual tax return, to name a few.
In general, there is more complexity and administration to consider in maintaining and planning for the future with a corporation. The mental overhead must also be considered, and partnering with advisors you trust can help to manage this. While I’ve mentioned many tax and estate planning opportunities for a corporation, these are not always low-hanging fruit. Often, corporate planning strategies require more decisions to be made each year in order to optimize the use of the corporation. Neglecting these decisions can result in unnecessary costs or taxes.
The corporation is a separate legal entity, and it requires tax, legal, and financial planning that is unique to its circumstances.
While losses in a sole proprietorship can be used to offset other personal income, losses incurred in an incorporated business cannot be distributed to the shareholder. Losses in a corporation can be used to offset corporate income in the past three years or any future year, but they cannot be used to offset personal income.
In some cases, a corporation may be deemed a Personal Service Business (PSB) in the eyes of the CRA. A PSB does not get the same preferential tax treatment as a small business. It loses the ability to deduct many of its expenses, making the corporate structure detrimental from the perspective of tax efficiency.
A PSB may be deemed by the CRA to exist if the business owner would otherwise be considered an employee of their client if not for the corporation. Specifically, as outlined in the Income Tax Act, you may be operating a PSB if the following conditions are met:
To avoid a PSB designation in situations where you are acting in a capacity similar to an employee, it is helpful to take on multiple contracts through the corporation. The more the better, but even one additional contract helps. Contracts with the corporation’s clients should outline the consulting nature of the relationship, should afford flexibility in the work schedule, and should reflect limited supervision with respect to how work is completed.
The good news: there is no need to rush in setting up a corporation. If a sole proprietorship or partnership becomes successful and accrues assets, these assets can be moved into a corporation on a tax-deferred basis by way of a section 85 rollover. This should take the pressure off for business owners to make a quick decision to incorporate before they can determine whether the business will work out in the long run.
It may still be unclear whether a corporation makes sense in your situation. You certainly do not need to incorporate to start a business, but there are financial planning benefits to consider.
A corporation is a useful planning tool if you are concerned about personal liability from your business activities, if you are earning more in your business than you can spend personally, if your business is saleable, and relatedly, if you want to raise capital. If you meet these criteria and your business is not a personal services business, the benefits of incorporating still need to be weighed against the additional costs and complexity this will introduce.
This is a complex decision. It is prudent to consult with tax, legal, and financial planning professionals to get specific advice for your situation.
