When starting a business in Canada, one of the most important decisions you must make is whether to incorporate or operate as a sole proprietorship. This can have financial, tax and liability implications.
It partly depends on your goals. If you are primarily serving as a consultant or freelancer and do not expect to add employees to generate millions in revenues, you can consider a sole proprietorship. On the other hand, if you have developed an exciting new product or ground-breaking software, you may choose to incorporate so that you can eventually sell shares to investors or even the general public.
Fortunately, you can change your mind as your business grows by incorporating a sole proprietorship. You can convert a sole proprietorship into a corporation by paying a government fee ($360 in Ontario) and getting a lawyer to help you set it up. You may even be able to use the same name (provided it’s available) and add the word Inc or Ltd at the end.
Similarly, if you own a corporation and decide to semi-retire or scale back your business, you can close the corporation and go with a sole proprietorship.
The primary difference between a sole proprietorship and a corporation is the legal structure. A sole proprietorship is just you personally. So, if your business is sued, you are liable. A corporation is a separate legal entity with limited liability.
There are different tax strategies depending on which option you choose and the profitability of your business.
If you have a sole proprietorship, you report any income from the business directly on your personal tax return. During the start-up phase, you may have some business losses and these can help to reduce your income for tax purposes. Therefore, you may end up paying less tax.
Incorporation can have tax benefits. Companies are taxed at a lower rate than personal income, so you may end up paying less tax. In addition, you can choose to keep money in the corporation rather than distribute it to shareholders (such as yourself) as a dividend. This can help to reduce your personal tax owing.
Sole proprietorships do not offer this flexibility. Any income that you earn from your business must be reported directly on your personal income tax return – and you will have to pay tax on it.
As noted above, with sole proprietorships you simply report your income on your personal tax return.
Corporations are separate legal entities. You can pay yourself a salary or distribute the company’s net income as a dividend. Alternatively, you do not have to pay yourself any compensation at all. You can keep all of the money in the business and not have any personal income to report.
One of the biggest differences between the two business structures is the need for professional advice from lawyers and accountants.
If you decide to start a corporation, you will need legal advice in order to set it up. On the other hand, it’s simple to register a sole proprietorship. You will need a Master Business License if you operate under a name other than your own.
Similarly, the need for accounting services is a difference between a sole proprietorship and a corporation. With a sole proprietorship, you simply report your income on your personal tax return – so you may not need an accountant at all.
For a corporation, you may need assistance from an accountant to file the required corporate tax return. You also will need a lawyer to draft corporate resolutions on an annual basis.
Dividend vs. Salary
If you have a sole proprietorship, your income must be taken as a salary. There are more options with corporations. You can pay yourself a salary or take the entire amount as a dividend – or opt for a combination of both. Dividends receive favorable tax treatment so you may want to look into which option works best for you.
With corporations, family members (such as your spouse) can be shareholders and therefore eligible to receive dividends. Your spouse can also be an employee provided that he/she legitimately works for the company. These strategies allow you to split income between you and your spouse, which may reduce your tax liability.
Risks of a Sole Proprietorship
With this type of business, you are personally liable for any debts or judgments resulting from a lawsuit. This means that your assets, such as personal savings and your house, can be seized to meet these financial obligations.
It can be difficult to raise capital if you decide you need funds to expand your business. That’s because you cannot offer investors shares in your business, like you would if it were a corporation. If your business carries a lot of risk, you may prefer to set it up as a corporation.
When you decide to retire, it can be difficult to sell a sole proprietorship. On the other hand, a corporation lives on even if you die; it can be easily sold if you or your heirs can find a willing buyer.
Risks of a Corporation
There are not a lot of risks with incorporating, but there are disadvantages. These include the requirement to file a separate tax return and keep corporate records. Normally, you will need an accountant to help you with your corporate income tax return, which adds an extra layer of cost.
When you set up your business, you can weigh the pros and cons of a corporation vs. a sole proprietorship. It’s a good idea to consult with your accountant and lawyer to get advice on which is best for your particular situation.
Are you already incorporated in Canada?
Small business owners and incorporated individuals in Canada can use a Health Spending Account (HSA) to save on their medical expenses. An HSA is a cost effective alternative to traditional health insurance. The plan covers a wide variety of health and dental expenses. You could save thousands of dollars in taxes with an HSA.
Find out more about Health Spending Account (HSA), download my free guides: