July 4, 2012
Incorporation vs. Proprietorship
One of the biggest considerations for small businesses is whether to incorporate or to operate as a proprietorship.
What’s the difference?
The main difference between corporations and proprietorships is that corporations become their own legal entity while proprietorships are operated under the name of the proprietor. From a tax perspective a corporation is taxed on its own, while a proprietorship is taxed on the proprietor’s personal tax return.
To Incorporate or Not
Like most big decisions there is no general rule but rather a number of considerations that must be evaluated in each unique situation to make the determination. The most common scenario for small businesses is to start as a proprietorship and then incorporate when it becomes beneficial to do so, which depends on a number of factors
Benefits of Incorporation
- Year to year Tax Planning opportunities
- Income splitting – Opportunities to pay salaries and dividends to family members to maximize the use of lower marginal tax rates.
- Tax deferral – Corporate tax rates are much lower than personal tax rates, owners may choose to only withdraw the funds they need, and leave the remaining funds in the corporation without paying high personal tax rates.
- Small business rate – To support small business, businesses are given the “small business deduction” which is a reduction on corporate income taxes of 17% on the first $500,000. The combined provincial and federal corporate tax rate on the first $500,000 of active business in British Columbia for 2012 is 13.5%.
- Limited Liability – In general the shareholders liability is limited to amount of money that they have invested in the corporation.
- Unlimited Life – Corporations do not end with the death of the shareholder, this can be useful in families as the family business can be passed down from generation to generation.
- Estate Planning – As discussed above, with the proper corporate structure and tax planning having a corporation allows the owner to pass down the business from generation to generation with limited tax consequences.
- Raising Money – Whether public or private, having a corporation allows for a simple method of raising funds for the company by selling shares. For example you could sell 40% of the shares of the company to raise funds to invest back in the company, while maintaining majority ownership.
- Legitimacy – This may seem superficial, but potential clients/customers may feel more comfortable dealing with a business that has Ltd., Inc, Corp,. or other similar characteristics as they may see these types of businesses more stable, established or legitimate.
Disadvantages of Corporations
- Increased Costs – Having a corporation requires the retaining of a lawyer and an accountant, and in the initial year professional fees may be a few thousand dollars, and from that point forward yearly professional fees are likely to be north of $1,000/year. In most cases (if companies are big enough and profitable) these costs are more than made up for in tax savings.
- 2nd tax return to prepare – As corporations are their own entity they have to file tax returns, corporate tax returns are more complex than personal tax returns and a designated accountant (CA or CGA) should be engaged to complete this work.
- Increased paperwork and responsibility – Being the majority shareholder of a corporation carries certain responsibilities such as ensuring corporate documents are filed annually, ensuring corporate tax returns are filed on time, and ensuring all corporate and financial records are in good standing.
- Liability may not be limited – When corporations borrow money the lender may require the owner to sign a personal guarantee, which would then extend the financial liability of the company to guarantor shareholder.
As you can see there are many factors to consider when making this decision, there are obvious occasions when a corporation is appropriate. If a business is has grown to a point that a business is making $500,000/year this would be a situation where a corporation would be appropriate, or if an individual has a small side business where they are earning $10,000/year this would be a situation in which a proprietorship would be appropriate. For businesses that fall between these two scenarios I would recommend getting professional advice to determine the best option for you.
If you are considering starting a business or have a business and are considering incorporation, please contact us at firstname.lastname@example.org , 604 510-0156, or visit our website at http://www.wattsca.ca for more information.
Disclaimer: The information in the blog is for general information only and is not intended to be a substitute for professional advice. Each person’s situation is unique, and a designated professional accountant can assist you in using the information on this blog to your best advantage. The author of this blog strives, but does not guarantee, to provide information which is current and accurate. Due to the nature of the information, it should not be relied upon for decision making without talking to a designated professional accountant. By obtaining information from this blog, you fully release Steve Watts, Chartered Accountant of any liability that may arise from using this information.