Why Would a Sole Proprietor Want to Incorporate? 0

Posted On February 1, 2024, by Trevor Buttle

Businesses in Canada can be structured in three ways — sole proprietor, partnership, or incorporation. In order to decide which option is the right one for your business at any given time, you need to better understand the pros and cons of the different structures.

Sole Proprietorship vs Incorporation

The definition of a sole proprietorship is contained right in the name — there is one owner who carries all of the responsibility and makes all of the business decisions. If you operate a business as a sole proprietor and have no partners or shareholders, you are personally responsible for profits and losses. This means you must file all of your business income as part of your personal tax return, and your income is taxed at a personal rate, meaning there is no distinction between your personal income and your business  On the other hand, when you incorporate your business, it becomes its own legal entity with its own financials, the benefits of which we share below. One of the first questions people ask when considering incorporation, is “how much revenue should I have before I incorporate”? Although this is a consideration, there are many others that could impact your decision. For example, how much of the profits will remain in the business, vs. coming to the owner every year; whether the business is seasonal in nature (e.g farmers or ski hill operators), or if the owner wants to conduct business with future estate planning or income smoothing in mind (e.g. parental leave, semi-retirements/slowing down, or support during periods of uncertainty).

If your circumstances change, and the considerations to incorporate become more positive – e.g. increased profit, tax planning, complexity of your organization, or limitation of liability concerns, you might want to consider incorporating.

It is possible to move between sole proprietorship and incorporation as your business grows or changes over the years. As your business grows, or other considerations make it beneficial to incorporate, you can “convert” your sole proprietor into an incorporated business. If you decide to scale back your business or semi-retire, you can wind-down/dissolve your incorporation and return to running your business as a sole proprietor. Your accounting professional can guide you through the requirements to make this change.

Benefits of Incorporating a Business

Transferring your business from a sole proprietorship to an incorporated company can offer some key advantages, including:

Limited Liability

Operating a business involves a risk of incurring losses or accruing debt, sometimes as a result of litigation. Although, insurance is something that helps protect the business, whether or not it is incorporated, within a sole proprietorship, you may be forced to relinquish personal property, such as your car and home, to pay business debts that may occur above and beyond insurance coverage.  We always recommend reviewing your insurance needs with an insurance professional with experience in your industry.

On the other hand, incorporation limits the owners’ personal liability, preventing them from being held legally responsible for a wide range of actions, as the corporation is a separate legal entity.  Banks and other creditors will often ask for personal guarantees from the owners, which would take precedence over the corporation, but other unsecured creditors would not be able to access your personal assets.

Tax Benefits

Various tax benefits are among the primary reasons businesses incorporate. Incorporated businesses are taxed at a lower rate than those that are not (Small Business Deduction available for Active Business Income in Ontario is just 12.2% at the time of writing). Although the rate differs from province to province, you can save money over time if you choose to incorporate.

In the case of a sole proprietorship, business owners are taxed at personal rates on the business’ profits – even if they do not take the money as a draw/income. On the other hand, corporations can decide how they will pay their shareholders. Dividends, and/or salaries, are a few ways a corporation compensates its shareholders, benefiting from lower income tax rates.

Last week’s blog covered Personal Services Businesses (PSB’s). If you think CRA might consider you to be an “incorporated employee”, you’ll want to check out that article https://www.gba-llp.ca/navigating-the-complex-world-of-personal-services-businesses-psbs/ and also speak with your accounting professional.

Income Tax Deferral

It is possible to defer personal taxation on your business income by leaving it in the corporation until you need it. The period during which funds remain in a corporation is commonly known as tax deferral. In the case of surplus profits, they can be reinvested into the business or used for other purposes, providing you with tax deferrals on those profits until you withdraw the funds from your corporation.

Credibility & Ability to Raise Capital

Incorporation may also boost your business’s credibility with customers, suppliers, employees and potential lenders or investors.

There are no formal mechanisms that allow sole proprietorships to sell shares of their company to potential investors, which limits their ability to raise capital. These businesses mostly rely on personal loans when it comes to funding. Alternatively, incorporated businesses may have access to a wider variety of financing options.

Name Protection

In some Canadian provinces, like Ontario, registering as an independent contractor does not protect your name. This can harm your business since any other individual can register their company with the same name and even potentially require you to change it should they decide to incorporate. Conversely, if you incorporate, your name will be protected by the jurisdiction where you are registered.

Easier Ownership Transfers

Corporation owners are not in direct possession of company assets. Instead, each shareholder owns shares of the corporation, which in turn owns the assets. As a result, it is much easier to transfer ownership interests (in the case of shareholder departure or death) and attract investments.

Lifetime Capital Gains Exemption (LCGE)

This is one of the biggest advantages of incorporation when it is time to sell your business. Unlike unincorporated companies, where you personally sell the property and assets, liquidating a corporation differs as you sell an independent entity with its liabilities and assets.

Under the LCGE, you might be able to be tax exempt on all or a portion of the profits when you sell your incorporated business. For a corporation, the 2024 capital-gains tax exemption limit is $971,190. This means that the LCGE allows you to deduct $1,016,836 from your profit and only pay the taxes on the difference. As an added benefit, the LCGE has a cumulative lifetime limit, and you can use it until you reach it. As the legal people say, certain conditions apply, speak to your accounting professional.

Is There a Downside to Incorporating a Business?

Choosing to incorporate a business comes with several disadvantages owners should consider.

Extra Paperwork

Incorporation does add to the administrative duties of a business owner. Corporations must file corporate tax returns and annual returns, in addition to the income tax returns the owners must file personally. Furthermore, a corporation’s minute book must contain several records, including articles of incorporation, bylaws, meeting minutes, and director, officer, and shareholder lists.

Additional Costs

Due to the complexity of its legal structure, a corporation is more expensive and complicated to set up than a sole proprietorship. For starters, incorporating a business, whether federally or locally, can cost several hundred dollars. Additionally, you pay annual fees, ongoing accounting and tax, and legal costs.

Conclusion

There are many different considerations in the choice to operate as a sole proprietor or a corporation. Ensure to leverage your trusted advisors (especially your accountant and lawyer) when making the choice that is right for you and your business.

Join us at GBA LLP on LinkedIn for the upcoming segments of this series. Our dedication to guiding the entrepreneurial heart across Canada remains unparalleled. Dive deeper at GBA-LLP.ca.

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This blog is not meant to provide specific advice or opinions regarding the topic(s) discussed above. Should you have a question about your specific situation, please discuss it with your GBA advisor.

GBA LLP is a full-service accounting firm in the Greater Toronto Area, but we primarily service all of Ontario as well as the rest of Canada virtually, except Quebec. Our team of over 30, provides Audits and Reviews of financial statements, and Compilations of financial information, as well as corporate tax returns.  We provide specialized corporate tax and succession planning for small and medium businesses, in addition to general advisory services.

If you would like to schedule a call to discuss your accounting or tax needs with one of our team members, please complete the free no obligation meeting request on this page.

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