Sole proprietorships vs. corporations If you are a sole proprietor, you may wonder when or if you should incorporate your business. Not surprisingly, the answer depends on your unique circumstances. A number of factors related to both you and your business need to be examined. These include profit expectations, expansion plans, your marginal tax rate and how much income you need. Also relevant is whether your family members plan to work or invest in the company. Business structures and business income (loss) The Canada Revenue Agency (CRA) defines a business as an activity where there is a reasonable expectation of profit and where there is evidence to support that intention. 1 This would include a profession, a trade, or a manufacturing operation. For income tax purposes, the net business income (or loss) is calculated by totaling the income from the business and deducting eligible expenses. Income would include revenue from the sale of goods or the provision of services. Many expenses that are deductible for accounting purposes may also be deducted when calculating taxable income. Sole proprietorship A major advantage of most sole proprietorships is lower costs. A sole proprietor does not have to bear the burden of government registration fees, shareholder meetings and preparation of corporate tax 1 http://www.cra-arc.gc.ca/tx/bsnss/sm/sttng/menu-eng.html returns, which together can add up to thousands of dollars a year. As well, there is minimal regulation and decision-making is generally easier. Some of the strategies available to sole proprietorships include 1. Maximize use of loss carryovers. It may make good sense to maintain the status quo as a sole proprietor for the start-up period if losses are expected especially if the owner has other income. As the owner and business are not separate entities, losses from the business may be applied against the owner's other income (employment, investment, rental, etc.) to reduce overall taxes payable. Losses from the business that cannot be used in the current year may be claimed retroactively for three years or forward up to 20 years. The carry-forward option is especially beneficial if the taxpayer expects to be in a higher tax bracket in the coming years. For losses to be deductible, the CRA will require that the business is conducted in a commercial manner in the pursuit of profit. 2. Pay family members. Proprietors can pay their spouses or other family members a reasonable salary for work they have done to support the business. This could augment losses that may be applied against the business owner's other income or reduce income taxable to the owner, as well as provide the opportunity to take advantage of lower tax brackets of family members, if applicable.
3. Consider incorporation once profitable. It may be beneficial to incorporate the business, once profitable, using a tax-free rollover of assets. Assets of the business can be transferred to a corporation at tax cost in exchange for shares of the corporation without any immediate tax consequences, providing certain criteria are met (regarding the nature of the property being transferred and the characteristics of the corporation). Owners should seek legal and tax advice before undertaking this type of transaction. Partnership In a partnership, two or more parties (such as individuals or corporations) join together to carry on a business. Each partner is entitled to a share of the business profits. Net business income is calculated at the partnership level and is allocated to the partners in accordance with the partnership agreement. The partners report their share of the business income as they otherwise would. For example, an individual partner includes the business income and expense items on a personal tax return, while a corporate partner reports these on a corporate tax return. Keeping it separate Since a small business is owned personally, whether by a sole proprietor or an ownermanager of a corporation or by a partnership, business and personal expenses may become comingled. For example, a business owner may find it easier to deposit cheques from clients to a personal bank account, or to charge business expenses to a personal credit card. It is important to clearly define which charges are for business purposes, since these can be deducted on a tax return, and which charges are non-deductible personal expenses. One of the easiest ways to distinguish business from personal expenses is to have two separate bank accounts: a personal account and a business banking account. It s also a good idea to have two credit cards, one for personal spending and the other for business use. Most people automatically open separate bank and credit accounts for a corporation since it has its own legal identity. It is just as important for sole proprietors to separate their accounts, although many overlook this essential step. Having a separate bank account and credit card for any business will make tax time a lot easier when it comes to separating business and personal expenses and can also come in handy in the case of a CRA business expense audit down the road. Incorporated business While complexity increases with incorporation, owner-shareholders can enjoy significant benefits over sole proprietors. One advantage is limited liability for the debts of the business shareholders can only lose what they invest in the company. There could be liability on Corporate directors, in some circumstances. If the corporation were to be sued, creditors could only go after the resources and assets of the corporation. In contrast, sole proprietors have unlimited liability for the debts of the business since owners and their businesses are not considered separate entities. Note that if the shareholder of an incorporated business provided a personal guarantee e.g., for a bank loan the asset pledged as security (or the owner's other personal assets, if a general guarantee is provided) would be at risk if the loan were to go into default.
Incorporation can also facilitate: The ability to divide and transfer ownership of the business Eligibility for certain provincial tax incentives or holidays The potential continuation of the business after the retirement or death of a shareholder Additional benefits and strategies available to corporations 1. Qualify for the small business deduction. In 2015, the first $500,000 of active business income of a Qualified Small Business Corporation (QSBC) attracts a federal tax rate of 11%. All provinces have reduced tax rates for the first $400,000- $500,000 of small business income so that the combined federal and provincial tax burden ranges from 11% to 19% of income under the small business income threshold. The remainder is taxed at combined rates ranging from about 25% to 31%. While personal tax will also be paid by the shareholder when the after-tax income is distributed, the personal tax can be deferred by delaying payment of salary or dividends if the shareholder does not immediately need the funds. Sole proprietors and partners, on the other hand, are taxed at individual marginal tax rates on any income received. 2. Find the optimal remuneration mix. Corporations have the flexibility to issue dividends, salaries, bonuses, stock options or share plans, or to repay loans or capital to shareholders who have provided capital to the business. The optimal remuneration mix for a shareholder/employee will depend on many factors, including the shareholder/employee s marginal tax rate, the shareholder/employee s cash flow requirements, the corporation s tax rate, provincial health and/or payroll taxes, the desire to maximize RRSP contribution room, CPP contributions, and the need to reduce the shareholder/employee s alternative minimum tax exposure. 3. Use the $813,600 2 lifetime capital gains exemption Capital gains on the sale of shares of a QSBC may qualify for the $813,600 Lifetime Capital Gains Exemption (LCGE). The LCGE can be used to reduce taxes when individuals sell their QSBC shares to third parties or family members, or in the event of their deaths. 4. Multiply the $813,600² LCGE. With proper planning, the LCGE may be used by each family member who is a shareholder. This could be accomplished by having family members buy shares at the inception of the business with their own money, or through an estate freeze, whereby the family members acquire common shares for a nominal amount. Tax experts must be consulted to ensure such transactions are properly undertaken. 5. Income split. If your spouse and adult children are shareholders in the corporation and their shares were acquired for fair market value, any dividends they receive will be taxed in their hands. Your corporation can also employ your family members as long as the amount paid is reasonable for the work performed. Note that most opportunities for ownershareholders to income-split with minors have been eliminated. 6. Pay a retiring allowance. Allowances paid upon retirement to salaried employees, including a shareholder, may be transferred into an RRSP on a tax-free 2 This amount is for the 2015 Canadian Tax return and indexed to inflation, using the Consumer Price Index data as reported by Statistics Canada.
rollover basis in some circumstances. Since the ability to roll over a retiring allowance to an RRSP only applies to employment periods prior to 1996, a retiring allowance has little benefit for employees of newer companies. Proprietors and partners cannot roll over a retiring allowance to an RRSP. 7. Continuation of the business at retirement or death. Since a corporation is considered a separate entity, it continues after the death or retirement of its shareholders. Owner-shareholders can pass the shares in the business to family members or others during their lifetimes or through their wills. This is another advantage of a corporation over a sole proprietorship, which terminates when the owner retires or dies. The ownershareholder can sell their shares as a going concern and receive a lump sum and/or a vendor take-back loan. With a family business, the owner may want to retain shares to supplement retirement income. A sole proprietor or executor for a sole proprietor, on the other hand, may sell or transfer only the assets of the business on retirement or death. A potential pitfall in incorporating a small business If a person terminates their employment with their company, incorporates a business and then their former employer hires them back as a consultant, they may think they will be able to enjoy all the advantages of incorporation, including lower corporate tax rates and the ability to income split. This is not necessarily so. The federal government discourages this kind of move through a number of restrictions that apply to what it calls a "personal services business." It considers a corporation to be conducting a personal services business if its shareholders or related persons provide services that would be considered services of an employee in the absence of the corporation. Among the restrictions: 1. Income from a personal services business is not considered active business income. As a result, it does not qualify for the small business deduction and is taxed at the general corporate rate. 2. The government generally limits the expenses that are deductible in calculating the income of a personal services business to salary, other benefits paid to the "incorporated employee," and certain expenses that would normally be deductible by an incorporated employee in selling property or negotiating contracts. 3. Remuneration paid to individuals other than the incorporated employee is not deductible by the corporation. 4. There is no advantage to accruing bonuses on behalf of the incorporated employee, since remuneration is only deductible in the corporation when paid. 5. There is currently generally no tax deferral advantage of retaining income in a corporation carrying on a personal services business. Generally, a corporation will not be seen to be a personal services business if it employs more than 5 full-time employees throughout the year or if the services are provided to an associated company. If you are considering quitting your job to establish an incorporated business for tax or income-splitting purposes, see a tax professional before handing in your resignation. How businesses are taxed is quite complex and these are just a few of the issues to consider. There are also other non-tax factors to think about when determining the right structure for your small business, such as legal matters.
Consult with the appropriate advisors, including tax and legal professionals, before starting your small business. Finally, small business owners need to know that winding up a corporation can be more complex than terminating a sole proprietorship, as it triggers both tax and non-tax costs. Tax costs may include capital gains tax on the appreciation of shares. Non-tax costs may include legal and accounting expenses. Generally, a sole proprietor who winds up a business will only pay tax on income earned during the year, plus any income tax on the disposition of business assets. Before sole proprietors incorporate their businesses, they need to weigh the pros and cons of sole proprietorship versus incorporation. They should also have an accurate picture of their overall needs and goals, and what resources are required to achieve these goals. Proposed Changes to the Lifetime Capital Gains Exemption (LCGE): The 2015 Federal budget included a proposal to increase the LCGE to $1 million from $813,600.00 for capital gains realized on the disposition of qualified farm or fishing property occurring on or after April 21, 2015. Quebec has also proposed an increase its provincial LCGE for qualifying farm and fishing property, located anywhere in Canada, from $800,000 to $1,000,000 starting in 2015. These proposals had not been enacted at the time of publication. For more information talk to a CIBC Advisor at any branch call 1 800 465-CIBC (2422) go to www.cibc.com This article is based on information CIBC believed to be accurate on the date shown at the bottom of the article. Banking products and services are provided by CIBC. Investment products and services are offered by CIBC Securities Inc., a whollyowned subsidiary of CIBC and a member of the Mutual Fund Dealers Association of Canada, or by CIBC Investor Services Inc., a subsidiary of CIBC, a member of the Investment Industry Regulatory Organization of Canada and the Canadian Investor Protection Fund. CIBC and its affiliates and agents are not liable for any errors or omissions. CIBC and its affiliates and agents are not responsible for providing updated or revised information. This article is intended to provide general information only and should not be construed as specific advice suitable for individuals. Since a consideration of individual circumstances and current events is critical, anyone wishing to act on information in this article should consult his/her CIBC Advisor. Certain articles may discuss tax, legal or insurance matters. For advice on your specific circumstances, please consult a tax, legal or insurance professional. Any references in this article to Canadian tax matters are based on federal tax laws only, unless otherwise stated. Provincial tax laws may also apply and may differ from federal tax laws.