by Ron Clarke
Should I incorporate?
A question often posed by small business proprietors.
The initial guidance typically lies within two key areas.
Is there a need to reduce “personal risk” created by the business? Is there “profit” at the end of the year that remains within the business?
Both these act as a 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, a corporation 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 equipment.
This is particularly the situation for start-up corporations when no credit worthiness has been established for the corporation itself and the lender wants to ensure recourse.
Besides defaulting on financial obligations, what other risks warrant 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 insurances for liability and/or errors and omissions aren’t sufficient or don’t cover against identifiable risk, a case for incorporation can be made.
The second consideration for incorporating is the level of profit that is retained within the business.
Since Canadian Controlled Private Corporations have the first $500,000 of income taxed at only 11 per cent, this tax rate is more attractive than the personal rate for proprietors — personal taxpayers in general — of anywhere from 20 per cent to 53 per cent of taxable income.
It’s a no brainer then!
Why wouldn’t you incorporate?
Consider this.
At the end of the day, when all the business bills are paid, is the remaining cash needed to make personal ends meet?
To pay all the personal bills? If the answer is yes, then the “profit” will be drained from the corporation to pay for personal living expenses.
The cash will be paid out as wages to the owner and therefore will be taxed at the higher personal tax 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 tax rate, nonetheless the benefit of the corporate taxation scheme is diminished.
In other words, whether paid as wages or dividends there may be little 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 will be significant.
Or is it that simple?
Investment income produced from retained earnings is considered passive income and only the first $50,000 of it is eligible for the 11 per cent tax rate, and amounts greater than $50,000 reduce the amount of eligible income to be taxed at 11 per cent.
To the extreme, the tax rate for the corporation could be 27 per cent, which is the tax rate for corporate income over $500,000.
So growing a large investment nest egg within a corporation is not necessarily the answer.
These points summarize the initial look-see at incorporation.
There are more complex scenarios with other options that may be applicable to consider.
To this end, consulting with legal and accounting professionals may be wise before making the decision whether to operate as a proprietorship or corporation.
Ron Clarke, owner of JBS Business Services in Trail, provides accounting and tax services.
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