Should You Incorporate?
By Reeh Taylor on 2013/04/18
Incorporating a business is somewhat more expensive and complicated than a sole proprietorship and, possibly, more so than creating a partnership, but there are a number of potential advantages. Virtually all large businesses are incorporated because of these advantages, but many small business owners choose not to incorporate because of the perceived expense and the complexity. Often small businesses operate as sole proprietorships or partnerships for a few years, and incorporate later when they are thinking about expanding.
The key thing to understand about incorporation is that an incorporated company is a separate legal entity. – that is, separate and distinct from its owners (the shareholders). It can make its own contracts, buy its own supplies, hire its own employees, etc. A sole proprietor or partner, when ordering supplies for the business, makes payment with her own money, whereas a corporation will have its own bank accounts and will make payment with its own funds. Money paid to the business belongs to the corporation, and must be formally paid out to the shareholders (if at all) in the form of dividends or, if they are also employees, as salaries or bonuses.
As far as the law is concerned, a corporation is able to do almost anything a person can do. Of course, a corporation can’t actually do anything on its own — it can only act through people. But it can hire employees, and they can carry on the business. A corporation is controlled by a board of directors (although there need only be one director) who meet on a regular basis and make major corporate decisions. The day-to-day decisions are usually left to the senior management.
(i) Advantages of Incorporation
The most common reasons for incorporating are:
• to minimize personal liability for the debts and obligations resulting from the business activities carried on by the corporation; and
• to minimize total taxes paid.
There are other good reasons, as I hope to show you later in this memorandum.
(a) The Liability of a Shareholder
Compared to the role of a sole proprietor or a partner, that of a shareholder in a corporation involves minimal personal liability unless, of course, she has given her personal guarantee of payment to some particular creditors of the corporation.
Normally, as a shareholder, all I can lose if my corporation becomes insolvent or is successfully sued by a creditor or other claimant is the value of my interest in that company. If I have invested $10,000.00 in shares of the corporation’s capital stock, my maximum exposure to loss would, in the ordinary course, consist of that $10,000.00 plus the amount (if any) by which the value of those shares might have increased in the meantime.
We should, perhaps, note that if, in addition to being a shareholder, you also become a director of the corporation, some extra personal exposure to the liabilities of the business do arise — mostly due to one or another of a number of statutes. For example, the Income Tax Act makes directors personally responsible for a corporation’s failure to remit tax required to be conducted at source from employees’ salaries; a number of environmental laws, both federal and provincial, place responsibility for a corporation’s breach of those laws upon the shoulders of its officers and directors, as do Workplace Health and Safety Regulations. Those are just a few examples.
Compared to that of the shareholder, what is my liability as a sole proprietor or partnership?
Sole proprietors and members of partnerships (other than Limited Partnerships) are liable to creditors to almost the full extent of their personal and business assets. I say “almost”, because there are certain assets that cannot be taken and sold to satisfy the claims of your creditors. They are prescribed by the Executions Act and the Garnishment Act of Manitoba, and the Bankruptcy Act (Canada). These exemptions include the tools of the debtors trade to an aggregate value of $7,500, household furnishings and appliances to an aggregate value of $4,500, food and fuel for six months, all normal and reasonable clothing, and a vehicle to the value of $3,000 if necessary for the conduct of the debtor’s business or employment. The Garnishment Act also exempts a reasonable portion of the debtor’s earned income (usually 70 percent, unless a court orders something different) to allow him/her to live. With those exceptions, as a sole owner or a partner all your assets can be seized by the Sheriff on behalf of any creditor who obtains a judgment against you, or by Canada Revenue Agency, to satisfy a debt.
In addition, sole proprietors and partners will usually have government-imposed liability for such matters as income tax deductions at source, Workers Compensation and Employment Insurance premiums and Canada Pension Plan contributions for their employees, collection and remittance of Goods and Services Tax and Provincial Sales tax levies. These latter kinds of exposure can, in some circumstances, also apply to directors of corporations.
(b) Tax Advantages
• Under current tax law (April, 2013), the first $500,000 of the active business income of a qualifying small business corporation is taxed federally at a rate of 11%; the Manitoba corporate income tax does not apply if the business income is under $400,000.00. Once your operating profit reaches a level in excess of your personal needs, you can retain the excess in the corporation for use in buying new equipment, paying down bank or other loans, etc., having paid tax on that surplus at the lower rate. It is only when the profits are distributed in the form of salaries or dividends that they are taxed in the hands of the employee or shareholder.
• Since dividends from corporations may also receive more favourable tax treatment than straight salary, you can work out with your professional accountant the best ‘mix’ of salary and dividends in order to minimize your total tax, although Revenue Canada has been working to minimize this benefit. Dividends paid out by a corporation are not deductible as expenses from the corporation’s taxable income.
• For partners, as for sole proprietors, all net income of the business is taxable in their hands at their own, personal rates, whether they keep some of it in the business or not.
• If you start a corporation with working capital of, say, $25,000.00, you can invest a small portion of that in common shares of the corporation and the rest either by buying redeemable, preference shares or by merely loaning that sum to the company. Then, when the company’s cash flow permits it, you can have the company repay that loan or redeem the preferred shares, in whole or in part, without paying any tax on that return of capital. (If you make that investment by way of a loan, be sure to have the corporation sign a general security agreement in your favour and have your lawyer register it under the Personal Property Security Act. This will give your claim for repayment priority over the corporation’s ordinary, unsecured creditors if the business should fall upon hard times.)
• If, having built up the business, you decide to sell all or part of it, under present taxation laws the first $750,000.00 of capital gain from the sale of shares in a small business corporation is exempt from taxation. Once you have used up that $750,000.00 exemption, that’s it — any subsequent capital gains of that kind will be taxable. That benefit is not available to a sole proprietor or partner.
(c) Perpetual Succession
Another advantage of incorporation is that, when the owner dies or wishes to transfer the business to a purchaser or to someone else in the family, all that need to be transferred are the owner’s shares in the corporation. The assets of the business do not change hands — they continue to belong to the corporation. (I must also note that most commercial purchasers – as contrasted with family members or close friends – will usually prefer to buy assets rather than shares of a corporation.)
Since a shareholder normally has no liability for corporate debts even while she retains her shares, creditors of the corporation have no interest and no say in what she does with her shares. The shareholder may sever all ties with the company simply by transferring her shares to another consenting person, subject to any restrictions that may be placed on the right of a shareholder to transfer her shares in private or closely held companies. Those restrictions will usually be found either in the Articles of Incorporation or, more frequently these days, in a Unanimous Shareholders’ Agreement. (More about Unanimous Shareholders’ Agreements later in this memo.) Subject to those same restrictions, anyone may buy shares and become entitled to all the rights of a shareholder upon registration of the transfer at the company’s registered office.
(d) Estate Planning
The use of corporate shareholdings, with or without the agency of a family trust, can be a very useful tool in the planning of your estate in the future, in order legitimately to minimize the impact of taxation. You will, of course, need professional advice from your tax accountant and your lawyer in order to take advantage of those opportunities, and that may be some distance in the future. I only mention it now as one potential advantage of incorporation. Under some circumstances it may also be beneficial to have a spouse or other close relative or ‘significant other’ subscribe for some shares of a separate class of stock with his or her own money, right at the beginning of business operations. That will allow dividends to be declared on that class of stock and effectively split the income between husband and wife or other domestic partner for tax purposes.
If you and a domestic partner are both working for the Corporation, you may choose to pay yourselves by salary for dividends or, preferably, by a combination of both. We suggest you talk to your accounting adviser about this.
If, at some future date, you wish to take on one or more co-owners, or if you wish to allow some senior employee(s) to acquire an interest in the business, the corporate structure lends itself to this much more readily than does a sole proprietorship or partnership. Employees, for example, can be given or allowed to buy a different class of common shares than those held by you, so that, with either minimal or no voting rights, they can still share in corporate profits and growth. The same principle applies to family members whom you may wish to benefit without necessarily giving them too loud a voice in the management of the corporation.
(ii) Disadvantages of Incorporation
We mentioned, earlier in this letter, the limitations of personal liability for debts or negligence of the corporation. You should, however, be aware that a number of statutes, both federal and provincial, do make directors (but not shareholders) liable for the consequences of certain acts and omissions of the corporation.
The incorporation of your business, apart from the initial cost of doing so (about $1,300.00), will entail additional, ongoing costs. In particular, since the corporation is a separate legal entity it will have to file a separate income tax return, plus a simple form of annual return (and a fee of $50.00) required by the Manitoba Companies Office. As well, certain corporate records must be kept on at least an annual basis, although this is not an onerous task.
Incorporating may not be right for you, but it would be wise to talk with your accounting and legal advisors about the wisdom of doing so. If you are likely to want to do so in the future, now might be the best time to do it; if you leave it until the business is flourishing, it will probably be necessary to take steps to avoid payment of a tax on the capital gain you may realize when selling your business to your own corporation. Those steps will entail a valuation of the business, an election under the Income Tax Act of Canada, and a special agreement between you and the new corporation – expenses you can avoid by incorporating at or near the beginning.
This memorandum is not intended to be exhaustive; it is merely a basic guideline to some aspects of incorporating you might wish to consider. Talk with your professional advisors before making any decisions in that regard.
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