Should I Incorporate? What are my choices?

 

Should I Incorporate? 

Disclaimer: all information provided is meant for discussion, education or opinion purposes only and is not intended as professional advice. 
 
There's a long running belief that I run into, which is that to start a business you need to start a corporation. This isn't necessarily true, although it is often a good idea. What most people lack is an understanding of their basic options in Canada, so I want to go into a straightforward analysis of each form of business in Canada and the pros and cons of each.

Starting a business can be as simple as just saying that you are now a sole proprietor and looking for clients and customers. From a legal perspective there's not much to do; maybe you want to register a business name and make some initially optional registrations with Canada Revenue Agency for GST/HST and payroll (if you have staff). Your municipality might need you to buy a business license but that is usually restricted to a narrow range of business types. Altogether, the legal barriers to self-employment are pretty low.

But maybe that isn't the best choice for you. Depending on a number of different factors you may want to consider one of the following forms:

• Sole proprietorship
• Corporation
• Partnership
• Limited partnership
• Joint venture/co-ownership

Sole Proprietorship

This is the simplest form of business structure and generally has the least administrative cost and burden, although it also lacks certain protections and beneficial mechanics available to the other types.

First off, this type suffers from unlimited personal liability. You are the business, therefore you are personally liable for all debts, actions and other activities by the business. This can be especially worrisome if you have employees, agents or subcontractors as you could be sued for any of their actions and your home and other assets become fair game. Do not run your business without a strong insurance component, even if all you have to worry about is a slip and fall.

Second, there are no tax deferral opportunities with a proprietorship. Income of the business is taxed on your personal tax brackets at the same rates as employment income. In Manitoba this translates to a tax rate brackets of between 25.5% and 50.4% . Considering the corporate small business tax rate can be around 10% this can translate into a lot less money to issue down business debt or purchase equipment if you operate as a proprietor instead of a corporation, depending on your capital needs and debt levels.

Third, a sole-proprietor pays both the employee and employer share of the Canada Pension Plan (CPP) contributions on income between $3,500 and roughly $56,000. The rate is 4.95% for each side, so a total of 9.9% which translates to an additional amount owing of about $5,600 each year if you are earning at or above $56,000. Also, tuition and other credits don't apply to reduce CPP, so if you become self-employed right out of school be ready to pay at least the CPP. On the up side, you are exempt from paying Employment Insurance (EI), although you can opt into EI if you want to claim some parental benefits later. It's a permanent opt-in though, so you will be paying EI for the rest of your career if you remain self-employed. There's no reduction in the EI premiums to account for your not being able to claim unemployment.

There are some advantages to a proprietorship. Administratively, it can be simpler as you don't have to report a full financial statement for tax purposes. A modified income statement is input into your Personal Income Tax Return on form T2125 so your accounting and tax preparation costs are usually quite a bit lower compared to the other structures. Your legal costs are usually limited to contacts and agreements so those tend to be lower as well.

A proprietorship can also be useful to get some tax benefit from early losses: if you have a loss in some of your early years you can carry it back up to 3 years against other personal income from prior year T1's and receive a refund. In a corporation these losses would need to be carried forward and applied to income in future years as the corporation would have no history of income.

It's worth noting that if you want to transition your business to a corporation or partnership later you will want to engage a lawyer and accountant to execute a tax free rollover of your goodwill and other assets (known as a Section 85 rollover); so if you are thinking of running a proprietorship for a year or two before incorporating you may not wind up with much professional fee savings overall as the additional costs you save may go toward the rollover. Failure to rollover your assets correctly can result in a lot of avoidable taxes, particularly if there is a significant goodwill component. Talk to a professional.

A final point about becoming self-employed: everyone who is an employee gets in the habit of spending the cash that hits their bank account and getting a tax refund by default. This only works because your employer sends in all your tax, CPP and EI during the year and Canada Revenue Agency (CRA) skews the payroll tables so that you get a refund as it's easier and cheaper for them to cut you a cheque than it is to chase you to pay. Once you are self-employed it's your responsibility to hold back enough tax to pay. On $50,000 of income this could easily be $15,000.

Corporation

This is the most popular form of business structure and and often highly misunderstood by those that own them. Corporations are extremely useful in the following situations:

• Higher risk ventures or inherent liability;
• Multiple investors and/or owner managers;
• Ability to choose remunerations options and timing (wages, dividends, or both);
• Lower taxes available for reinvestment in the business;
• Tax deferral opportunities to build up retirement funds; and,
• Possible income splitting opportunities, although this has been reduced starting in 2018.

Limited Liability

Legally speaking, a corporation is a separate legal person. This means that the liability stops at the corporate level and won't flow through to your personal assets, unless you sign any personal guarantees (note: pretty much every bank loan wants a personal guarantee). This is very important when you may be operating higher risk ventures or ones that could be subject to lawsuits. You can even set up multiple corporations to hold assets separate from operations to protect against devastating suits. You should still get insurance of course.

This limited liability won't protect you from criminal actions, personal guarantees and some CRA liabilities if your activities as a director were to deliberately avoid paying taxes.

Multiple Owners and Investors

A corporation also makes sense when multiple owners and/or investors exist or may be added in the future. By setting up a flexible authorized share structure and consulting with professionals in accounting, tax and law it is possible to set up a structure that can allow for a large number of different shareholders and investors.

Voting rights, value ownership and other details needs to be carefully considered, otherwise unforeseen control and tax consequences can occur. For example, people who self-incorporate tend to split a single class of shares with a spouse; this is a problem as dividends are paid pro-rata to a class of shareholders, not to individuals. Therefore, if shareholder hold the same class of shares it is impossible to choose what dividends each shareholder will receive.

Remuneration Options

Unlike a sole proprietorship, an owner-manager shareholder is both an investor and an employee of the corporation. Consequently, it is possible to customize remuneration in a tax efficient way using the following tools:

• Paying a wage as an employee (subject to CPP; EI exempt if ownership is 40% or more among some other restrictions)
• Paying a bonus. Note that this will be deductible to the corporation immediately and taxable to the employee when paid within 180 days of the payable. Source deductions must be sent in to CRA to be considered paid. If the source deductions are not sent in within 180 days the bonus is considered not to have happened.
• Declaring a dividend. This is considered investment income and will not be subject to CPP or result in RRSP contribution room. Unlike a wage, there is no tax deduction but you will get a credit for corporate taxes paid on your personal return. 

Lower taxes on earnings

The corporate tax rate on a Canadian Controlled Private Corporation (CCPC) is one of the lowest in Canada. Federally, the rate for net taxable income earned on $500,000 is 10% in 2018. The provincial rates vary; in Manitoba it is 0% on $450,000, and 12% on income above $450,000.

These lower rates are very useful for pay-down of debt, investments in the corporation and capital asset purchases as the corporation will have significantly more cash available compared to the personal rates on a sole proprietorship. For contrast, the lowest personal rate on self employment in Manitoba would be 25.5% plus 9.9% for CPP, for a combined tax and CPP cost of 35.4% (without taking tax credits into account).

To summarize, if you are intending to reinvest your earnings into a business, $100 of income earned corporately would provide $90 after tax for reinvestment, whereas a sole proprietorship at the lowest rate would leave $64.60 for reinvestment. The personal rates will start increasing after approximately $35,000 of income.

Please note that you will not receive the benefit of the lower tax rate if you withdraw all the profits of the corporation for personal use as these drawings will need to be covered by either wages, dividends or a combination of both and will be subject to personal tax.

Tax deferral opportunities for retirement

As an alternative to personal investments and/or RRSP investments, corporate earnings can be left in the company and invested in portfolio investments, real estate, etc. This effectively allows you to take income that only saw 10% tax to be used for investment purposes, allowing for a return on part of the income that would otherwise have gone to personal taxes. These retained earnings will be taxable at personal rates in the future when the cash is withdrawn from the corporation.

The Federal government is currently assaulting some of this advantage under the banner of fairness, although considering self employed people don't qualify for pensions, RRSP matching, most EI benefits, paid vacation and many health benefits I'm somewhat skeptical about how unfair things were to begin with. Legislation has not yet been drafted but the current proposal is to have investment income over 50K subject to higher tax to remove this benefit. Presuming an average portfolio return of 5% this would imply that up to a million dollars of earnings could be retained as part of the investment portfolio which is still pretty significant. If you save $1,000,000 of funds that were only taxed at 10% in a corporation, you would have approximately $300,000 more capital invested. presuming the personal tax rate we are comparing against is around 40%. This would result in about $15,000 more investment income presuming a 5% return than if you held these investments personally.

Individual Pension Plans (IPP) may also be another advantageous option to implement within the Corporation but is beyond the scope of this post. They're starting to get a lot of attention due to these proposed rule changes.

Income splitting opportunities

Another traditional opportunity afforded by corporations has been the ability to issue dividend sprinkling shares (separate classes) to a spouse and/or adult children to pay retained earnings out as dividends to family members, allowing for lower overall tax rates for the family. This has been especially useful in situations where a child is going to university.

New legislation that came into force on January 1, 2018 has largely removed this benefit, although it is still possible to income split in a few scenarios, including shareholders over 65, shareholders who are active in the business and non-service based corporations (see the tests here). Everyone else is subject to a reasonableness test for dividends in a similar manner as wages. I'm curious to read the inevitable Tax Court cases that this new legislation will generate and if these rules are upheld.

Partnership

A traditional partnership, also known as a general partnership, has one major flaw: unlimited personal liability in the same manner as sole proprietorships. This can be especially worrisome as you can be held liable for agreements and behavior undertaken by your partner(s). One way to mitigate this is to have a corporation you own be a partner instead of yourself personally, but this results in more administrative cost in the form of legal and accounting.

A partnership is not a taxable entity, any income or loss of the partnership is flowed through and taxed in the hands of the partners. A T5013 information return which reports the income or loss to each individual partner needs to be filed with CRA within 3 months of year end (5 months if all the partners are corporations). The return is similar to a corporate tax return and requires a similar amount of work and cost to prepare from an accounting perspective .

One great advantage of partnerships is the ability to move partners in and out. Since each partner has a capital account that tracks contributions and undistributed earnings for each partner it is theoretically simpler to remove a partner without having the same considerations around valuations and share sales/redemptions that you see with a corporation. If you are adding a partner, a contribution can be made to a new capital account. In practice however, many general partnership agreements may lack provisions to make this straightforward so it could become complicated, particularly if there is considered to be significant goodwill. A brand new partnership agreement may need to be drafted in the case of removals/additions of partners which could incur significant legal costs.

Where partnerships really shine is when special income allocation arrangements need to be made. This may include allocations based on retained capital, direct billings, different types of income or really anything else that is desired. The agreements are almost infinitely customizable in this regard, whereas corporations are fairly rigid with regard to paying earnings out to shareholders. This could be especially useful where voting rights need to be unchanging but income levels vary year to year such as when they are based on lawyer direct billings for a year.

It also bears mentioning that tax adjustments such as Capital Cost Allowance (taxable depreciation) and non-deductible adjustments are applied at the partnership level before taxable income is allocated to each partner.

Limited partnerships

A limited partnership (LP) is similar to a general partnership but it gets around the unlimited liability issue by introducing the concept of limited partners. A limited partner's liability is limited to the amount contributed by that partner. Consequently, the deductibility of any taxable losses allocated to a limited partner is limited to the contributions and undistributed earnings of that partner.

There should still be at least one general partner that has unlimited liability; this is normally a freshly incorporated company that is allocated a nominal amount of income each year (such as 0.01%).

Limited partnerships are very useful in situations with a large investor class, particularly where partners may move in and out often and where more exotic income allocations are required. Large real estate projects are prime candidates to be a limited partnership.

Joint ventures/Co-Ownerships

Joint ventures and co-ownerships are for practical purposes almost identical, although in the case of joint ventures there is usually a more robust agreement in place.

Joint ventures are usually shorter term in nature when two or more agencies come together to collaborate on a project and each contribute assets and/or expertise. Similar to a partnership, income allocations can be organized to be more complex amongst the venturers.

Co-ownerships are generally more long-term, such as when an apartment building is owned by many owners which may change periodically. Income is usually allocated based on ownership percentage.

In both cases, they are not considered entities in their own right by CRA so no additional tax or information reporting needs to be made, although income still needs to reported in the tax return of the owners, be they personal or corporate. Unlike a partnership, tax adjustments such as Capital Cost Allowance are recorded at the owner's level, so it is important to keep track of their share of any capital assets held. Other items such a GST/HST often have to be reported by a single designated owner.

Summary

As you can see, the "correct" form of business for you can depend on a number of factors, including taxation, number of owners, administrative and reporting costs, long term plans and level of income. All of these variables need to be considered in consultation with a professional before pulling the trigger, as fixing a bad structure can be even more expensive later.

Author: Michael Glazier is a Chartered Professional Accountant and legacy Chartered Accountant providing a range of accounting and tax services to his local Winnipeg area and remotely to clients across Canada. He has over 12 years of experience in personal income tax, corporate income tax, assurance and various specializations and experience in accounting and tax issues around R & D, investments, projections, valuations and paperless transition. You can find out more by visiting the Glazier CPA website or by emailing at mglazier@glaziercpa.ca.