WHEN SHOULD YOU INCORPORATE YOUR PROPRIETORSHIP OR PARTNERSHIP ?

Three Business Structures are:

Proprietorship, an unincorporated business owned by one person.

Partnership, an unincorporated business owned by two or more people.

Corporation, a separate legal entity owned by one or more shareholders

 CONSIDERATIONS:

• The Corporate accounting records will have an account called the Shareholder loan account which will keep track of funds Due from and Due to the shareholder.

• If incorporating ensure all invoices are in the corporation’s name, otherwise Canada Revenue Agency can challenge the input tax credits claimed on the HST return and corporate expenses.

• In some situations there is an additional Corporation which owns the shares of the operating  corporation. This additional “Holding Company” requires extra analysis and planning.

• If your business is incorporated you will need to compensate yourself via T4 or T5 or a blend.

  This offers greater planning for your personal taxable income. The T4 can include a salary or

  year-end management bonus which is an expense to the corporation.  The T5 is for a dividend paid to a shareholder and is not subject to Canada Pension Plan.

• At some point the business owner will have to consider the sale of the business (assets and business goodwill). Business goodwill is an intangible asset resulting in a purchaser paying a premium over and above the fair market value of the tangible assets. Not all businesses will generate goodwill.

  An alternative to the sale of a business may be a succession plan to transfer the business, possibly to a relative of the business owner. If there is business goodwill and a taxable capital gain, there will have to be an analysis to determine which business structure will result in the least amount of income tax payable on the taxable capital gain.

• Adequate business liability insurance must be maintained whether you have a proprietorship/partnership or a corporation.

• Certain businesses that are at higher risk of a legal claim should be incorporated immediately to limit the personal liability of the business owner.

ADVANTAGES OF INCORPORATING:

• A Corporation operates as a distinct legal entity and exists until it is dissolved by the shareholders. It allows for selling of shares to investors or the outright sale of the corporation by the selling of all shares. This offers continuity beyond the original shareholders involvement and complex succession planning.

• Limited Personal Liability – personal assets are separate from corporate assets.  If you are operating your business through a corporation liability is normally limited to assets held within the corporation. Your personal assets would not normally be at risk should the corporation fail to pay their liabilities. However, Corporate Directors can be held personally liable for a corporation’s failure to remit certain taxes, such as payroll deductions, (e.g., CPP, EI, and income tax) and HST. For corporate loans it is common practice of financial institutions to require personal guarantees from corporate shareholders thus personal assets would then be at risk if there is a corporate loan default.

• The annual management bonus deferral which is achieved by declaring a management bonus payable. This bonus payable is then paid within 180 days of the declaration date, usually the next year.

• Income tax deferral: Depending on the Province and other factors corporate income taxes are approximately 11-12.5 % when claiming the small business corporate deduction. There is only a tax advantage to incorporating if income is left in the corporation and not distributed to the shareholders as a wage or dividend. Additional personal income taxes will be payable when the shareholder is paid a wage or a dividend. When all income is distributed to the shareholders the total income tax paid by the corporation and personal income taxes will be approximately that paid by a proprietorship or a partnership.

DISADVANTAGES, EXTRA COSTS OF INCORPORATING:

• A new business often incurs losses in its early years because it has start-up costs and low revenues while it is getting established. If the business is incorporated and incurs losses, the losses will be incurred by the corporation and not deductible against your other sources of income.  A new corporation can carry forward losses and apply them to reduce taxable corporate income in future years. However, business losses from a Proprietorship or Partnership are deductible from other sources of income on a personal T1 income tax return which results in less total income tax payable and usually a refund. Therefore, if you anticipate losses in your start up years and you have sufficient income from other personal sources you might defer incorporation until your Proprietorship or Partnership is profitable.

• A section 85 transfer and CRA form T2057 will need to be completed if you are transferring an existing business (proprietorship or partnership) to a corporation and there is a gain to defer. 

• A corporation can have one or more shareholders. If there is more than one shareholder a legal shareholder agreement must be completed.

• For a corporation the annual T2 income tax return and financial statements usually have  higher annual accounting fees than an annual T2125 (proprietorship or partnership tax return). There is more bookkeeping and accounting required for a corporation. Accounting, legal and other fees to start, operate and close a corporation are higher than those for a proprietorship or a partnership. A corporation will require a corporate minute book. The corporation’s minute book serves as the official record of the corporation’s activities. Essentially, the minute book should document all material corporate transactions that affect and involve the corporation.

CONCLUSION

Not all proprietorships or partnerships need to be incorporated. For example, when personal liability from the business is minimal and the business owner will withdraw all profits from the business annually, a business owner (usually a small business) might not incorporate.

If your business is started as a proprietorship or partnership, when required, it can be transferred to a corporation at a future date.

Whether or not you incorporate depends on many factors such as: losses in early years, type of business and associated risks, tax planning, excess annual income over owner withdrawals, income splitting, tax deferral, insurance, personal assets, new invention, seeking additional shareholders/investors, when business is to be sold, raising of capital, succession planning, growth expectations of business, etc.

For assistance in making the correct decision consult with an experienced, qualified Business Advisor.

Article written by John Costen, CPA, CGA, CFP