When starting a small business, you have a few choices on how to legally structure it. You can organize your business as a corporation, sole proprietorship, or a partnership. What you ultimately choose will have a significant effect on the amount you pay in taxes. This article will focus on the various advantages of incorporation vs. operating a sole-proprietorship or a partnership.
The Small Business Tax Rate
In Alberta, Canadian Controlled Private Corporations (CCPC) are taxed at a low effective rate of 14% on active business income (as opposed to inactive investment income). The specific breakdown is 11% federal and 3% provincial. This low rate is not available to sole-proprietors or partnerships as their business income is taxed at their personal marginal tax rates.
Keep in mind, as a corporate shareholder, you still will pay personal tax on funds you draw from the business for personal use; either by means of a salary or a dividend. The important point here is that a corporate shareholder is able to set their personal income by controlling the amount he or she draws from the business. This is a tax deferral opportunity that operates similarly to contributing to an RRSP, except instead of putting money into an RRSP investment account to lower your personal income, you simply don’t draw the funds from your corporation in the first place. The corporation is your RRSP!
Income Splitting
When you incorporate, the biggest decision you’ll be faced with is how to apportion the ownership of the company. Many of our clients find it beneficial to add their spouses as a shareholder to make them eligible to receive dividend payments. This can be an effective way to “income smooth” between spouses, lowering the family’s average tax rate.
It is worth noting that it is not recommended to add minor children (under 18) as shareholders due to corporate income attribution rules. These rules result in dividend income to a minor child being attributed back to the child’s parents where it is taxed at the parents’ marginal tax rates.
Opting Out of the CPP
As a sole-proprietorship, you have no choice but to pay into the Canada Pension Plan (CPP). Your sole-proprietorship income (revenues less expenses) is multiplied by 9.9% to determine the payment (capped at $4.613.40 in 2012). It is 9.9% rather than the typical 4.95% because as a self-employed person you are responsible for both the employee and employer portion of the CPP.
While CPP can be a valid way to save for your retirement, some clients choose to invest that money back into their growing business or within an investment fund held within the business.
As the shareholder of a corporation you have the flexibility to compensate yourself as an employee via salary or as a shareholder via dividends. If you choose the dividend path of remuneration no CPP would be payable. Ultimately, a business owner is able to choose which remuneration choice best fits their situation and goals. Your Origami accountant is always available to discuss the choices and their ramifications for you and your business.
Lifetime Capital Gains Exemption
By virtue of owing an incorporated company, you have the potential to shelter taxes due from the sale of your corporation with the Lifetime Capital Gains Exemption. This means that should you ever sell the shares of your business to an arm’s length party, the first $750,000 of the capital gain is tax free. As capital gains are taxed at 50%, the total taxable capital gain that you can avoid paying tax on is $375,000. Should you grow your business and in the future choose to sell it, this is a significant tax savings opportunity that is not available to sole-proprietors or partnerships.
Limited Legal Liability
A major benefit of incorporating comes from the legal realm in that an incorporated shareholder is not personally liable should the corporation be found liable for damages in a lawsuit. Unlike a corporate shareholder, in the event of a judgment against the business, a sole-proprietor’s and partners’ personal assets are potentially at risk. While a business insurance plan with proper coverage can cover your sole-proprietorship or partnership, it is still an important distinction to be aware of. Please note that some debts fall outside the scope of corporate limited liability. The directors of a corporation are personally liable for any unpaid GST or employee source-deductions, regardless of the status of the corporation.
A Reason Not to Incorporate
You might find yourself asking if there remains any reason to organize your business as a sole-proprietorship or a partnership? Well, in my mind there is only one. It is when this business could be accurately described as a part-time “hobby business” you operate on the side while earning employment income elsewhere. The professional fees (legal and accounting) that go hand in hand with incorporation tend to overwhelm the profits of the hobby business.