If you are reading this, you are embarking on entrepreneurship, you have a great idea, and you are one step closer to realizing your dream of owning your own business.
Or you may already be on your way and need a little assistance!
Here’s what you should know.
Sole Proprietorship versus Incorporating – What’s the difference?
This is a question we are frequently asked and is a very important one for small business owners to consider. We explain below the differences between the two by comparing the advantages and disadvantages of incorporating versus maintaining a sole proprietorship.
Legal status and limited versus unlimited liability
Legally and for tax purposes, a sole proprietorship is simply an extension of the individual. A corporation, however, is its own entity and recognized as such by Canadian corporate law and the Canadian tax system, completely separate to the individual(s) who have started the corporation. This is a very important distinction to keep in mind as you will note in the topics below.
Therefore, one of the biggest advantages of incorporating your business is that the liability is typically limited to what the business is worth. If the corporation is sued or named in a lawsuit, it is only the assets of the corporation at stake. There is no personal liability for the shareholder(s).
Something to keep in mind when in the process of obtaining small business loans is that banks will require a personal guarantee from the shareholder(s) because of the limited credit history of the corporation, which does offset some of the advantage described above.
On the other hand, the liability for sole proprietors is unlimited as the proprietor’s business and personal assets are all at risk given the proprietor is personally liable for all debts and/or lawsuits.
Registering a Business in Ontario
Set up and registration for sole proprietorships is considered to be inexpensive, and relatively quick and easy. One of the first steps sole proprietors will need to take is to register their business with the province and obtain a business license in addition to any other licenses/registrations required depending on the industry they are operating in. Sole proprietors will then need to inform the CRA to obtain a business number for the purpose of filing HST returns and remitting payroll deductions.
Once the above steps are completed, you’re typically on your way!
Incorporating is a bit more involved and generally more expensive. Before incorporating, you will need to decide whether to incorporate federally in Canada or provincially in the province you are operating in. This is a key decision if you foresee any possibility of moving the place of operation of your business from one province to another. Either federally or provincially, you will need to submit articles of incorporation.
In setting up a corporation, you will need to determine from the onset who the shareholders of the business will be (i.e. you, your business partner(s), etc), how much voting control each shareholder should have, and what classes of shares should be established. It is important that these decisions are made upon incorporation as making changes once the business has matured can be complicated and also costly.
Once you have received a corporation number, you will be able to register with the CRA and open up the necessary program accounts (i.e. HST, and payroll).
Business Continuance and Permanence
As mentioned above, a sole proprietorship is an extension of the individual and therefore, when the individual dies, the business may not transfer so easily to heirs or another individual.
A corporation can technically live on even in the event of the death of the original shareholder, which depending on the long-term vision for your business, may be a great advantage.
HST registration and returns
If your business, whether you are a sole proprietorship or incorporated, generates less than $30,000 of revenues, there is no requirement to register for HST.
However, once your business’ revenues are in excess of $30,000, you are required to register for HST immediately, collect HST on every dollar of revenue over $30,000 for the first time this threshold is crossed and remit to the CRA as per the prescribed frequency (i.e. monthly, quarterly, or annually). The following year, you will need to collect and remit HST on all revenues your business generates, not just the revenues in excess of $30,000.
As mentioned above, as part of the set up of your business, you should ensure that you have registered online with the CRA and have opened an HST account to allow you to file your HST returns and make your HST remittances as required.
Tax planning – Business Tax Exposure
Tax planning is the most significant consideration to the decision of whether to incorporate or remain a sole proprietor. A sole proprietorship’s net income is subject to the progressive tax rate system for personal tax. A corporation’s net income is subject to the corporate tax rules which for most Canadian small businesses translates to corporate tax of approximately 15% on the first $500,000 of profits.
Here are two hypothetical examples to illustrate the difference:
Example A – Sole Proprietorship
Person A started a business on January 1, 2018 and decides to operate as a sole proprietor. In 2018, Person A reported a profit of $200,000. Because Person A is a sole proprietor, the business is an extension of Person A, as described above, the $200,000 of income is reported on Person A’s T1 personal tax return. Assuming Person A is a resident of Ontario, Person A should expect to pay a total of $74,000 in federal tax, provincial tax, and CPP premiums. This is an average tax rate of 37%.
Example B – Incorporating
Now, let’s say Person A decided to incorporate their business on January 1, 2018 and calls it OpCo Inc. and also records a profit of $200,000. Business tax (also referred to as corporate tax) on this profit will be $30,000, given OpCo Inc. will have access to what is known as the small business deduction, which reduces the corporate tax rate to approximately 15%. Person A, as the 100% shareholder of OpCo Inc. now has $170,000 left in the corporation and can decide whether to keep the profits in the corporation for reinvestment in the business or to distribute out to himself/herself by way of salary or dividend.
Tax Planning – Compensation Strategy – Salary Versus Dividend
Carrying on from Example A above, there are no options available in terms of compensation strategy for sole proprietorships. This is because every dollar of profit earned by your business as a sole proprietor is subject to personal tax based on the progressive tax rate system.
However, in Example B, Person A has options available on how to extract the $170,000 from the Corporation as the sole shareholder and most importantly, Person A has options on when to extract the money. Person A can extract the profits from the corporation via salary or dividend and can decide whether all of the profits should be extracted now or only partially, which is commonly referred to as a tax deferral. Scenarios are explained below:
A shareholder of a corporation can choose to pay themselves a salary as an employee of the Corporation any wage they would like at any time of the year. Person A could put themselves on the corporation’s payroll, paying themselves periodically (bi-weekly, semi-monthly, etc) while remitting the appropriate payroll deductions (tax and CPP) or pay themselves a lump-sum bonus at the end of the year and remitting payroll deductions one time only at the time of the bonus payment.
Whether it’s a periodic salary or annual bonus, the amount paid out to the shareholder will be a deduction to the Corporation’s profits and the amount issued as a salary/bonus will be taxed under the personal tax system. In other words, salary/bonuses are paid out using before-corporate tax dollars.
As a shareholder of a corporation, dividends would be the other compensation option available to you. Unlike the salary option above, dividends are paid out using the after-corporate tax dollars and therefore do not count as a deduction against the corporation’s profits for the year. In Canada, there is a dividend tax credit mechanism which lowers the amount of personal tax individuals would have to pay upon receipt of dividends.
The decision to draw salary/bonuses from your corporation or declare dividends should be decided based on your circumstance and your short and long-term goals. The tax rates and impacts differ in all scenarios.
For example, $50,000 of salary/bonus drawn from your corporation would result in a tax and CPP charge of $11,000. However, due to the way the dividend tax credit system works, $50,000 of dividends from your corporation results in just $3,550 of tax for a 68% tax saving of $7,450. It is important to note that when dividends are declared, CPP is not contributed to. Thus, if an individual only has dividend income, they will have no CPP contributions which will impact their future CPP claims.
Tax timing and deferral
The most powerful tool at your disposal, however, with the use of a corporation is the ability to defer tax by not extracting profits from your corporation all in the same personal tax year. For instance, as per Example A, $200,000 of income reported for personal tax purposes would result in approximately $74,000 of personal tax.
However, if a salary of $100,000 was paid in year 1 instead and in turn, a $100,000 profit was reported in the corporation (due to salaries of $100,000 being deducted from the $200,000 profit), there would be a personal tax charge of approximately $28,000 and a corporate tax charge of $15,000, resulting in a total tax charge of $43,000. This is a $31,000 tax saving which is 42% of the tax that would have been originally owed had all business profits were taken as wages in the same tax year.
In year 2, you could then draw the remaining $85,000 ($200,000 year 1 profit less $100,000 of year 1 salary less $15,000 of year 1 corporate tax) as a dividend, which would result in a personal tax charge of approximately $12,000. In total, the aggregate tax across year 1 and 2 relating to year 1 profits would be $55,000, which is $19,000 less than the $74,000 of personal tax that would have been originally owed as described above.
The above is just one example of how tax deferrals can work to your advantage with the right compensation strategy in place.
Tax Planning – Income Splitting in Corporations (i.e. Income Sprinkling)
As mentioned in the earlier sections, an incorporated business can issue shares to anyone. A strategy that can be considered is to issue shares to certain family members (i.e. wife and children). There is an opportunity to split the income earned in the corporation across the shareholders by way of dividends. This is also known as ‘income sprinkling’. This would help lower the amount of personal tax payable as the total profits of the corporation are split in multiple ways versus just one individual declaring all of the profit personally via salary or dividend.
It is important to note there are new income sprinkling rules prescribed by the CRA which requires careful consideration which we would assist in navigating.
Tax Planning – Use of Business Losses
An advantage a sole proprietor has over corporations is that any losses incurred as a result of doing business can be offset against all other sources of personal income. A common example of this would be an individual who works full-time earning a salary of $100,000 a year who decides to start a side-business venture. This individual anticipates that in the first 3 years, there will be losses incurred. This individual also plans to continue working full-time earning a salary of $100,000.
Those 3 years of business losses can be used as a deduction against the $100,000 of employment income, therefore lowering the personal tax charge.
If this individual had incorporated their business, the losses would be trapped in the corporation and would only be able to be applied against the corporation’s profits at a future date (note that losses are carried forward for 20 years for corporations).
Tax Return Submissions & Compliance – Sole Proprietorships versus Corporations
On an annual business as a sole proprietor, the financial results of your business would be reported using the T2125 – Statement of Business Activities form on your T1 personal tax return.
For your corporation, a T2 Corporate Income Tax Return would be filed on an annual basis based on the year end date that is determined for the corporation.
What’s right for me?
After being armed with the above information, it may still be difficult to decide on what the appropriate next step is.
It is ultimately a function of the industry you are operating in, your projected business profits for the next 5 years, as well as your short and long-term goals for yourself and for your business.
Generally speaking, the more profit your business generates, the more favourable it would be to incorporate given the several advantages cited above.
We would encourage you to come in for a free consultation so we can go over your ideas, circumstance, and business plan together and advise you on what the next best step is for yourself and for your business.
We look forward to hearing from you and helping you achieve your vision and dreams for yourself and for your business!