Whether you’re in your first year of business or you’ve been an independent contractor for decades, you may be thinking about the possibility of incorporation. There are certainly advantages to incorporating as a business, such as a potentially lower tax rate, reduced debt liability, and better access to business loans. However, incorporation also requires more work on your part when it comes to keeping detailed records and filing reports. Incorporation can be helpful, but it isn’t the right choice for every contractor.
What Is an Incorporated Business?
Before looking at the pros and cons of incorporation, you need to understand the differences between a sole proprietorship and a corporation.
A sole proprietorship is a business structure where you are the only person involved in the business. Essentially, you and your business are one and the same in the eyes of the Canada Revenue Agency. Your business income is taxed at the same rate as personal employment income. If you find yourself in debt, creditors have the ability to make claims on your personal assets, such as your home or your vehicle.
Incorporation turns your business into an independent entity that is legally separate from you. You become a shareholder of your corporation. Because your business is now separate from you, you have less personal liability if your business goes into debt. Additionally, your business income may be taxed at a lower corporate rate.
The Cost of Incorporating
The first, and often the largest hurdle to overcome when you choose to incorporate your business is the cost. Filing for incorporation carries a fee of $200 as of 2017. Consult an accountant to help set up your expense reporting and payroll systems. A tax lawyer can help you go over your books as you restructure your business.
The steps involved in incorporating, such as registering for a business number and adding additional shareholders, take time. Before filing for incorporation, take into account not only the upfront costs and the time costs that will be required.
One of the most attractive aspects of incorporation is the corporate tax rate. In Canada, most provinces and territories have a lower rate and a higher rate for provincial income tax. Incorporated small businesses are eligible to claim the small business tax deduction, which allows for business income claimed under the deduction to be taxed at the lower rate. Any non-business or non-deductible income is taxed at the higher rate. The difference between the two rates can be significant. For example, in British Columbia as of 2017, the lower rate is 2.5%, while the higher rate is 11%.
If you are a sole proprietor in Canada, all of your income — regardless of whether or not it was business income — is taxed at the higher rate. If you choose to incorporate, you could save a significant amount of money on taxes.
Incorporation also allows for the possibility of income splitting via dividends. For example, if you have a spouse or common-law partner who makes less money than you, you can name that person as a shareholder in your corporation and pay that person a portion of your fiscal income as a dividend. This reduces your net business income, potentially lowering your overall tax payment. There are restrictions on the practice of paying dividends, and this is only an option if your income is significantly higher than that of your spouse or partner.
Access to Funds
If, as an independent contractor, you hope to expand your business, incorporation can improve your ability to fund your small business. Imagine, for example, you’re a contracting massage therapist, working out of your own home or from a clinic location. Say you wish to expand by renting your own space, and potentially hiring two or three employees.
If you incorporate, you have can attract investors by offering bonds or shareholder certificates. You may also be able to borrow money at a lower rate than you would as an individual. Banks tend to see corporations as safer options for lending, so you may be able to borrow more. Numerous Canadian grants are available to small businesses — as a corporation, you would be eligible to apply for some of these.
If you remain a sole proprietorship, you are reliant on your own savings and income to fund your business. It may also be more difficult to borrow money from a bank, because your income as an individual is less reliable than someone who receives a salary.
Once you incorporate your business as a separate legal entity, the business will continue to exist even after your death. In the case of the above massage clinic example, the business property and all related deeds, loans, and grants could transfer to your heir upon your death. That heir could then decide to dissolve the business and inherit the liquid assets, sell the business, or take over as the primary shareholder and potentially continue to make a profit.
The main determining factors for whether you should incorporate your business are overall income and plans for expansion. If you’re an independent contractor with no plans to expand into a small business, sole proprietorship is likely to be the better option. If you wish to expand someday, or you’re making significant profits as a contractor, incorporation can be helpful.