A corporation is the most common business structure in Canada. There are many benefits to incorporating your business, including income tax, legal and funding considerations.
To fully understand the advantages of incorporation, it is helpful to possess a basic understanding of the other business structures available to entrepreneurs, these being sole proprietorships and partnerships.
Alternative Structures to Corporations
The simplest business structure is the sole proprietorship. A sole proprietorship exists where an individual operates the business personally. All income or losses of the business are reported directly on the personal tax return and all of the assets and liabilities of the business are owned personally.
The advantages of a sole proprietorship include:
- low start up costs;
- few formalities; and
- business losses can be used as an offset against other personal income.
The disadvantages of operating as a sole proprietorship include:
- unlimited liability, where all personal assets of the proprietor are at risk to creditors of the business; and
- difficulty in attracting investment and funding.
A partnership exists where two or more individuals (or corporations) carry on business together with a view to a profit. Like a sole proprietorship, the partners carry on the business directly. All assets and obligations of the partnership belong to the partners, and the income or loss of the partnerships flow through to the partners.
There are two types of partnership:
General Partnership – every partner shares in the management of the business and is an agent of the partnership business and the other partners, and every partner is jointly liable with the other partners for the debts and obligations of the business.
Limited Partnership – a partnership that provides limited liability for some partners. General partners have the same rights and duties as partners in ordinary general partnerships. Limited partners are passive investors and are not permitted to be active in the control and management of the business. Limited partners are only liable for the debts and obligations of the limited partnership up to the amount that they have agreed to contribute to the partnership.
The advantages of partnerships include:
- ease and low cost of formation for a general partnership;
- business losses flow through to the partners for deduction against income from other sources;
- limited liability for limited partnerships; and
- limited partnerships can be used to attract investors.
Partnerships also have several disadvantages including:
- unlimited liability for partners in a general partnership and for general partners in a limited partnership; and
- higher costs to set up a limited partnership.
Many businesses start out as a sole proprietorship or partnership because of the ability to flow the startup losses out to the proprietor or partners. As the business becomes viable, the business is then incorporated.
A corporation is a separate legal entity from the owners and management. Corporations can operate a business, acquire assets, incur liabilities, enter into contracts, pay taxes, etc.
Advantages of Incorporation
There is a reason that most businesses in Canada choose to operate as corporations. Incorporation has a number of advantages over other business structures.
One of the main reasons for incorporation is limited liability. Shareholders of a company are not liable for the debts and obligations of the business. Unless shareholders have guaranteed the debt of a company, their liability is limited to the amount that they have invested. Directors of a company can be held liable for unremitted payroll source deductions and GST / HST.
Greater Access to Capital and Resources
A corporation provides several alternatives to investors. A company can take out loans or issue shares to investors. Issuing share allows investors to acquire an ownership interest without any liability issues. Many investors will not consider investing in a business that is not incorporated.
When a corporation is used, key employees and advisors can be rewarded with stock options.
There are often government grants and programs available to new businesses, usually only available to corporations.
Incorporation adds a sense of professionalism to your business, compared to a sole proprietorship. Credibility is extremely important in attracting investors and in dealing with banks and vendors.
Scientific Research and Experimental Development (SR&ED)
The federal and provincial governments offer investment tax credit incentives through the SR&ED (pronounced “shred”) program. The investment tax credits (ITC) can be used to reduce corporate income tax payable, or may be refunded to the corporation when it is not taxable.
A Canadian Controlled Private Corporation (CCPC), a Canadian incorporated private corporation that is not controlled by one or more non-residents of Canada or public corporations, qualifies for a refundable federal ITC of 35% of research and development expenditures up to $3,000,000 annually (plus 10% BC provincial credit). Expenditures in excess of $3,000,000 earn ITCs at 15%.
A non-CCPC or an individual is only eligible for ITCs of 15% on qualifying SR&ED expenditures.
Capital Gains Exemption
Canadian individuals have a lifetime capital gains exemption of $800,000. The gain on the sale of qualifying shares of a CCPC is tax free up to $800,000, which is a significant tax benefit for entrepreneurs (up to $180,000 for shareholders in the top tax bracket). The savings can be multiplied by issuing shares to spouses, children, or a family trust.
Lower Tax Rates
A CCPC in British Columbia is subject to income tax at 13.5% on the first $500,000 of active business income earned, and at 26% on business income in excess of $500,000.
In comparison, individuals are taxed at 43.7% on income between $136,000 and $150,000, and at 45.8% on income over $150,000.
A sole proprietor must pay tax at their marginal tax rates, including 45.8% on income in excess of $500,000.
By using a CCPC, income tax of up to 32% can be deferred. The reduced tax rate leaves more funds for the company to purchase assets, repay debt, and reinvest in the business.
Income splitting is the diversion of income from a person in a high tax bracket to a family member in a lower tax bracket so that the overall family taxes are lower. Spouses and family members that are not active in a business should not be paid salary (salaries that are not reasonable are not deductible), but income splitting can be achieved by issuing shares to family members and paying dividends.
Disadvantages of Incorporation
Incorporation does have some drawbacks. It is usually the most expensive business structure to set up and maintain, and the most complex. There are many more rules and formalities to be observed when operating through a corporate structure.
Losses of a corporation can only be claimed by the corporation. Start-up losses can be carried forward for deduction against future income, but do not provide any immediate tax benefit to the company, whereas losses of a sole proprietor or partnership flow through to the individual or partner and are available for immediate deduction against other sources of income.
Overall, the advantages of incorporation far outweigh the disadvantages.
For more information on incorporation or tax planning for your new business, please contact me.
A copy of this article appears on the GrowLab blog. GrowLab is a Vancouver-based startup accelerator that helps entrepreneurs build great companies through seed funding, mentorship, collaborative workspace and 3 months of intensive programming. GrowLab connects the best and brightest entrepreneurs from around the world with their global network of top tier investors, mentors and partners.