To incorporate or not

A question often posed by proprietors, “Should I incorporate?”

A question often posed by proprietors, “Should I incorporate?”

Guidance usually lies within two key areas.  Is there a need to reduce personal risk created by the business?  And, is there “profit” at the end of each month?  These act as the litmus test for incorporation since just one, or a combination of both, may make the case for incorporating a business.

Incorporating limits personal liability when it comes to business risk.  If sued, the business is its own entity and as such, only its assets or, ultimately, its net worth, is on the line.  However, if the shareholder signs a personal guarantee, then this protection is lost, at least for that particular item – let’s say a line of credit or a lease for a vehicle.  This is particularly the situation for start-up businesses when no credit worthiness has been established and the lender wants to ensure recourse.

There may also be risk beyond financial business obligations that warrants the mitigation of liability.  Is there an abnormally high physical risk to clients in terms of the product or even visitation to the place of business?  Is there risk of harm to clients in terms of the quality of the deliverables, or the lack or late delivery of the product or service for which they have engaged the business?  If errors and omissions insurance isn’t sufficient or doesn’t cover against this type of risk, a case for incorporation can be made.

The second area to consider is the level of profit that can be retained within the business.  Since the corporate tax rate is 26.5 per cent, and in the case of Canadian Controlled Private Corporations where the first $500,000 of income is taxed at only 13.5 per cent, it’s more attractive to have income taxed within the business than it is at the personal rate for proprietors of up to 43.7 per cent.

Incorporate!  It’s a no brainer, isn’t it?  But wait.  At the end of the day, when all the business bills are paid, is the remaining cash needed to make personal ends meet?  If the answer is yes, then the “profit” will have to be drained from the corporation to pay for personal living expenses.   The last of the cash will be paid out as wages to the owner and therefore have to be taxed at the personal rate.  Of course there will be no corporate tax since the “profit” has been expensed as wages.  Even if paid out as dividends to the owner, these funds come from after corporate tax dollars and then taxed personally, albeit at a preferred rate, nonetheless the benefit of the corporate taxation scheme is diminished.

In other words, whether paid as wages or dividends there may be little to no tax benefit for incorporation when all the profit has to be removed for spending to sustain personal life.

Conversely, if considerable profit can be retained within the business, then the tax benefit of incorporation can be significant in terms of corporate versus personal (proprietors) tax rates.  This situation presents a good case for incorporation.

If it’s a go, then how to incorporate?  It can be done on-line for minimal cost but if there is any complexity to the business or personal situation, using professionals may be the way to go but it could be up to $3,000 or more, especially if a holding company and family trust are integral to the corporate and personal plan.  On this point itself, at least consultation with legal and accounting professionals is likely wise before moving forward with incorporation.

Ron Clarke has his MBA and is a business owner in Trail, providing accounting and tax services. Email him at ron.clarke@JBSbiz.ca