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Corporation – Non-Tax Benefit
The number one non-tax reason to incorporate a business is for creditor proofing. Generally, a corporation provides creditor protection to its shareholder(s) through its limited liability status, a protection not available to a proprietorship. (It is important to note that certain types of professional corporations while protecting your personally from corporate liability, do not absolve the individual professional from personal professional liability). Where an incorporated business is sued and becomes liable for a successful claim, the only assets exposed to the creditors are the corporate assets, not the shareholders personal assets.
In order to mitigate the exposure that a potential claim could have on corporate assets, a holding company can be incorporated. Once the holding company is incorporated, the active corporation can transfer on a tax-free basis the excess cash and assets to the holding company to insulate those assets from creditors. The assets in the holding company cannot be encroached upon if there is a lawsuit against the operating company.
The inherent nature of certain businesses leads to the risk of lawsuits, while other business types have limited risk of a lawsuit. Thus, one of your first decisions upon starting a business is to determine whether your risk of being sued is high and if so, you should incorporate from day one.
Corporation – The Tax Benefits
There are several substantial income tax benefits associated with incorporation:
1) The Lifetime Capital Gains Exemption
If you believe that your business has substantial growth potential and may be a desirable acquisition target in the future, it is usually suggested to incorporate. That is because on the sale of the shares of a Qualifying Small Business Corporation, each shareholder may be entitled to a $750,000 capital gains exemption. So for example, if you, your spouse and your two children are shareholders of the family business (often through a family trust), you could potentially sell your business for $3,000,000 tax-free in the future. It should be noted that typically businesses that are consulting in nature, have limited value, since the value of the company is the personal goodwill of the owner.
Where you start your business as a proprietorship, it is still possible to convert the proprietorship into a corporation on a tax-free basis and to multiple the capital gains exemption going forward. A couple of points are worth noting here: (1) incorporating a proprietorship after the business has been operating for a few years may result in substantial legal, accounting and valuation fees; and (2) the value of the business up to the date of incorporation will belong to you and will be reflected in special shares that must be issued to you (assuming you will include other family members as shareholders in the new corporation).
For example, let's say you operate a successful business which you started as a proprietorship because you were unsure of whether it would be successful. The business has taken off and you have engaged a valuator to value the business prior to incorporating. The valuator has determined that the fair market value of your business today is worth $500,000. Upon incorporation, the $500,000 of value would be crystallized in special shares that would be owned by you. The new common shares that would be issued would only be entitled to the future growth of the business above and beyond the $500,000 and thus, any future capital gains exemptions for the new common shareholders would only accrue on the value in excess of $500,000.
2) Income Splitting
A corporation provides greater income splitting opportunities than a proprietorship. With a corporation it is possible to utilize discretionary shares that allow the corporation to stream dividends to a particular shareholder or shareholders (e.g. a spouse or a child 18 years of age or older) who are in lower marginal income tax brackets than the principal owner-manager.
Dividends are paid with after-corporate tax dollars from the business, whereas salaries, the alternative form of remuneration, are paid with pre-tax dollars and are generally a deductible business expense. The deductibility of a salary by a business is subject to a “reasonability test”. In order to deduct a salary from the business’ income it must be considered “reasonable”. Unfortunately, there is no defined criteria as to what is considered “reasonable”; however, paying a family member a salary of $50,000/annually who has little or no responsibilities within the business is likely not “reasonable”. However, with dividends there is no such “reasonability test”, so paying a family member a dividend of $50,000 even though she/he may have little or no responsibilities within the business is perfectly acceptable. Salaries to family members can be paid in an incorporated business or unincorporated business; however, the dividend alternative is unique to a corporation. Sole proprietors cannot pay themselves a salary; they receive draws from the proprietorship.
3) Income Tax Rate
The first $500,000 of active business income earned in a corporation is currently subject to a reduced income tax rate. Since the personal rate on income can be as high as 46%, income earned within a corporation potentially provides a very large income tax deferral, assuming these funds are not required personally for living expenses. This potential 30% deferral of income tax allows you to build your business with pre-tax corporate dollars. It should also be noted that once you take the money from the corporation, in many cases you essentially pay the deferred 30% tax as a dividend.