Scott Park CPA, CA
A common question I am often asked by entrepreneurs and those looking to create a new start-up business is whether they should start a proprietorship or incorporate?
And secondly, for those that have already started their business as a proprietorship the next question becomes when should they consider incorporation?
Non-Tax Related Benefit
The most important non-tax related factor in deciding whether to incorporate is creditor protection. A shareholder of a corporation is not personally liable for claims made against business debts as the only assets exposed to creditors are the corporate assets held by the company. However, please note that under certain circumstances, a shareholder would be personally liable for a corporate debt if the shareholder has provided a personal guarantee over that corporate debt.
This creditor protection mentioned above does not apply to a sole proprietorship as each owner would be personally liable for their business debts. Creditors that make a claim against a sole proprietorship could go after each owner’s personal assets to satisfy the debts to make up any shortfall (i.e. personal bank accounts, personal investments, house etc.).
Therefore, it really depends on the nature of business an individual wishes to start. Some industries are subjected to a higher risk of lawsuits while others may pose a low risk of encountering a lawsuit. If you find yourself in a high risk business then it would be prudent to incorporate from the start.
Tax Related Benefits
Now let’s discuss a few of the tax benefits that a corporation offers compared to a sole proprietorship.
Income Tax Rates & Deferrals
In BC, the corporate tax rate for a Canadian Controlled Private Corporation (CCPC) in 2017 is 13.0% on the first $500,000 of active business income. In comparison, the top personal tax rate that would apply on the income earned by a sole proprietorship in BC is as much as 47.70%. This represents a potential savings of 34.7% in tax deferral as long as the income remains in the corporation.
Lifetime Capital Gains Exemption
There is a lifetime “capital gains exemption” of $800,000 (indexed to inflation after 2014; $813,600 for 2015) that can be claimed against taxable capital gains on the sale of shares designated as Qualified Small Business Corporation (QSBC) shares. Please note that long term planning is also necessary to ensure that the shares qualify as QSBC shares in order to take advantage of the LCGE.
The exemption, as the name implies, is limited to your total gains on qualifying property over your lifetime. There is no requirement to utilize the exemption all at once; you can carry forward any unused amount for future tax planning opportunities.
Therefore, if your business has significant potential for growth and would be a desirable acquisition target in the future then incorporation would be highly suggested. As long as the shares you are selling meet the requirements, the exemption can provide significant tax savings. For example, on a capital gain of $813,600 indexed in 2015 that did not qualify for the exemption, you would be taxed approximately $194,000 ($813,600 x 50% x 47.7%) in BC.
Income Splitting Opportunities
One popular income splitting tool for a corporation is the use of discretionary shares, which allows the directors of a corporation to pay dividends to select shareholders (e.g. a spouse or a child 18 years of age or older) a discretionary amount. In contrast, dividends paid on non-discretionary shares are paid based on the percentage ownership of the class of shares.
The main benefit of using discretionary shares is to income split with family members. For example, let’s assume that you are the sole shareholder of a company and you needed $40,000 to pay for your child’s post-secondary education. If you paid yourself the money as an eligible dividend, you would pay approximately $11,500 of income tax on that dividend (using 2015 BC tax rates and assuming you were already in the highest tax bracket). But, if you gave your adult child a class of discretionary shares they would have to pay very little if no tax at all. The use of discretionary shares will yield a tax savings of $11,500 in this case.
Disadvantages of Incorporation
Maintaining a corporation can be quite costly compared to a proprietorship for all the initial and ongoing legal fees and accounting fees to prepare financial statements and tax returns. Also, a corporation typically has much more in the way of administrative burdens to abide by.
Incorporating Your Proprietorship
Lastly, I will address the second question posed at the start – when to incorporate your proprietorship? Generally, it is advisable to incorporate your proprietorship when you realize that your business is a viable money making venture and if it is generating cash in excess of your personal day to day living expenses. This way you can take advantage of the significant tax deferral savings of approximately 34.7% as mentioned above.
As always, each person’s case is unique. Make sure you consult with your Chartered Professional Accountant to discuss your specific situation to obtain the best results.
Disclaimer: The blogs posted on Scott Park & Co Inc. website provide information of a general nature. These blog posts should not be considered specific advice since each person's personal financial situation is unique and fact specific. Please contact us prior to implementing or acting upon any of the information contained in one of our blogs.