Incorporation: Now, Later, or Never?

James Schofield - May 24, 2023
Are you a small business owner thinking about incorporation? There are several factors to consider, such as the tax rates in your province, your personal cash flow needs and how long you've been in business. Here we look into this in detail.

If you’re like most unincorporated small business owners, you've wondered: Should I incorporate? If so, when's the best time? If not, why not? The simple answer is, “Incorporation is always good because it delivers terrific tax benefits while creditorproofing your personal finances.” But like all most anwers in financial planning, this one is much too simplistic.

Whether or not to incorporate raises a diverse array of issues— among them; the length of time you've been in business, your personal cash flow needs, the relative profitability of your business, and the personal and corporate tax rates in your province. Let's take a closer look at how these and other issues in deciding whether or not to incorporate.

Cash flow and you

If you need all the profits from your business to support your personal cash flow needs, incorporation may not be for you because in this case, the cost of setting up and maintaining the corporation will exceed the direct tax benefits. However, when your financial position allows you to retain some of your business profits inside the company, incorporation could deliver significant tax savings as money retained in the company can be used to grow the operations or invest in other non-related investments.

Taxing questions and answers

When it comes to taxes, incorporation can be a double-edged sword. If you are in the initial stages of your business, it is usually advisable not to incorporate because losses incurred by an incorporated business do not flow through to shareholders. In the early stages, you’re better off if you can use those losses personally against your other income.

Once your business becomes profitable, incorporation can provide significant tax advantages. If your business earns active business income (income earned as a direct result of the operation of the business as opposed to passive income earned, for example, by holding other investments through the corporation) you may gain an immediate tax break (in some provinces) and the opportunity to defer part of your tax payment.

A Canadian controlled private corporation’s active business income is taxed at a relatively low combined federal/provincial rate of 12–19 per cent, (depending on the province). The lower rate is applied federally on the first $500,000 of active business income, but in some provinces the lower rate may be applied on an amount ranging from $400,000 to $500,000. Even though shareholders must pay more tax once the after-tax income is paid out as dividends, this second level of tax is applied only when the dividends are paid, allowing you as an owner to potentially reduce your taxes—by declaring dividends in years when your personal taxable income is lower.

Incorporation also allows you to take advantage of income splitting to reduce taxes. If your spouse or adult children are shareholders in your corporation, any dividends they receive will usually be taxed in their hands. Your corporation can also employ family members if their remuneration is reasonable for the work performed.You can defer certain expenses as well. For example, an incorporated business can report an employee bonus for tax purposes but may defer paying out the bonus money until after year-end. To be deductible in the year by the corporation, it must be paid to you no later than six months after the end of the year.

Creditor-proofing personal assets

Incorporation can limit your liability because corporate assets and personal assets are kept separate and corporate creditors only have a claim on assets owned by the corporation. For this reason many banks and other corporate suppliers often require small business owners to personally guarantee any liabilities and directors of a corporation may be liable for unpaid debts (including outstanding income tax, GST/HST, PST and employee source deductions) in such cases, incorporation may not protect you from creditors.

Retirement and insurance benefits

Your corporation can create a registered pension plan (RPP) and tax-deductible group health and life insurance for you and your employees, which can include family members. This pension plan option may provide higher retirement benefits than those available from investments in a registered retirement savings plan (RRSP).

A year of your own

Your incorporated business can choose any 12-month period as it fiscal year. You can select a fiscal year-end that coincides with business or cash flow peaks (making tax payments easier) or when corporate expenses are higher (potentially reducing your corporate tax bite).

Estate planning

The life of an unincorporated business usually ends with the life of its proprietor. But a corporation can continue to exist indefinitely, which is why corporations are often used for estate planning purposes. It is important to take steps so that after your death, the business remains profitable with sound management provided by successors.

If after assessing the pros and cons, you are leaning toward incorporation, you still have a few important decisions to make:

Who will be the shareholders? You may choose to make family members shareholders for income splitting purposes— but the ability to issue shares to family members is limited in certain corporate structures. We also don’t advise issuing shares to minor children. For that reason, it may be necessary to establish a family trust to hold the shares on their behalf.

Who will be on the board of directors? Directors have exposure to many different types of liabilities, so becoming a director is not a decision to be taken lightly.

Who should be the officers? These are the people entitled to sign contracts, banking, and other documents on behalf of the corporation. They must be chosen with care and with an eye to the future development and direction of your business

Yes, there are potential benefits to incorporation, but be sure to talk to us before you make the final decision.