Business Structures 101 – Incorporation

“I think I need to incorporate.”

This is a statement I hear regularly from new clients. Incorporation is sometimes viewed as the true measure of success for a business owner.

But before you run to the Corporate Registry office in your province to start the incorporation process, here are a few things to keep in mind about what it means to incorporate your business.

What is a corporation?

A corporation is created by legislation. You can incorporate a company under provincial legislation, or you can incorporate a company federally under the Canada Business Corporations Act.

A corporation is a separate legal entity from you. Once you are running your business through a corporation, you have now separated the business from your personally-owned assets.

As the “owner” of a corporation, you will own “shares” in the corporation as opposed to owning the underlying assets of the corporation. Keep in mind that if you had previously been operating your business as a sole proprietor, you may have “things” that need to be sold into the corporation so that you can continue operating the business through the corporate structure. Using my cupcake business as an example, I might have equipment (i.e., mixers, ovens), a lease for my bakery, inventory (i.e., cupcake liners, flour), and customer lists. If I am operating the business under my corporation, then my corporation should own all of these things, as opposed to me personally. Legal documentation (as well as tax filings) is required to properly sell those assets into the corporation.

How is a corporation taxed?

Because a corporation is a separate legal entity, it files a separate income tax return. Income is taxed within the corporation. Keep in mind that active business income (e.g., income from my cupcake business) is taxed differently in a corporation than passive investment income.

A second level of taxation in a corporation occurs when money is paid to an individual from the corporation. For example, if the corporation pays a salary to an employee, the corporation would have first paid income tax on the income in the corporation at a certain tax rate. Then the individual employee would pay tax on the income they received as a salary based on their personal tax rates.

Depending on the nature of your business, in addition to filing a corporate income tax return, your corporation may also need to file GST/HST and/or PST returns. For more information on this issue, please see Season 2, Episode 3 of The Tax Chick Podcast (featuring special guest, Jordan Brown of Lift Accounting) – we break down the basics of sales taxes in Canada.

What are the advantages and disadvantages to a corporation?

Here are some of the pros and cons of choosing to operate your business as a corporation:

PROS

Depending on the circumstances, a corporation can be a vehicle for tax deferral. However, if you are taking all the income you earn in the corporation and paying it out to yourself, the potential for tax savings can become obsolete.

It does have the potential to provide some creditor protection with respect to assets held within a corporation.

It is a more formal structure that is governed by rules and regulations set out in legislation.

CONS

It is significantly more complex than operating as a sole proprietor:

You have to file a separate tax return, and prepare a set of financial statements.

Income and expenses need to be tracked separately from your personal income and expenses. The corporate monies do not belong to you. Every time you take funds from the corporation, you have to categorize the payment – is it a dividend? A salary? A loan? A repayment of your shareholder loan? Depending on what categorization is chosen, additional documentation to support the payment will be required.

In many provinces, there is an annual filing requirement to the provincial Corporate Registry Office.

With complexity, there is often an increased cost for professional services. A corporation requires the filing of a separate, more complicated, tax return. The preparation of financial statements. Increased complexity in bookkeeping. Annual filings to provincial registry offices. Legal documentation to support payments to shareholders, and to record transactions happening within the corporation.

It is not necessarily easy to “undo” a corporate structure once it has been created. Legal documents need to be prepared to “wind-up” the corporation, and final tax returns need to be filed with Canada Revenue Agency.

Concluding Thoughts

The decision to incorporate is a big decision, and should not be taken lightly. It is so important to seek professional advice prior to embarking on an incorporation journey on your own. I am a firm believer in the power of establishing your business “team”. This is a great example of a time to lean on the expertise of your team to help you make this decision.

For example, you may wish to have a visit with your accountant or your lawyer to start the conversation. If you do not have an accountant or a lawyer, check in with the other members of your team (or other business owners in your community) to get a recommendation. Most professional advisors will offer an initial consultation meeting (typically for a set fee) where they will help you review the current needs of your business.

Some potential questions you may want to ask include:

Is it the right time to incorporate? My current income from my business is ______, and I am projecting income to be ______ in the coming year.

What will it cost to incorporate my business? What legal documents are required on incorporation?

How do I get my business assets from my sole proprietorship into my corporation? What does that cost?

What are the different kinds of “shares” in a corporation and how I do know what kind of shares I should own?

What is a director? What is an officer? What are their roles in a corporation?

How will incorporating change my current bookkeeping practices?

If you would like to hear more on this topic, I encourage you to listen to Season 1 Episode 4 of The Tax Chick Podcast, “A candid discussion on business structures”, with my guest Jared Pilon. In addition, if you are looking for some advice on bookkeeping, check out Season 1, Episode 1 of The Tax Chick Podcast, “Bookkeeping 101” with my guest Tasha Baier.

The information in this article is not legal advice. We encourage you to consult with your legal advisor for advice specific to you.