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Tax Implications of Incorporating Your Small Business

When you open your small business, you typically start out with an idea and a dream, but you may not give the business’s legal structure as much thought. By default, most small business endeavours begin as sole proprietorships. As you gain more customers or clients and grow in size, though, you might decide incorporating your small business makes sense due to the legal protection and financing options it provides. While incorporation is often a good idea for growing companies, the process has consequences when it comes to your taxes and requires you to make some careful decisions.

Incorporating a Small Business

Over time, you’ve probably acquired numerous company assets, whether in the form of real estate, vehicles, machinery, or inventory. When you incorporate, you need to transfer those assets from your sole proprietorship to the corporation you form. This transfer of assets is called a disposition in tax jargon. In simple terms, it just means that you and your small business are two different entities, and you’re selling your assets to your company. In return, your small business pays you with shares, debt, or a combination of the two.

You must make this transfer at fair market value since your disposition doesn’t occur at arm’s length, which means by unrelated entities. Because of this, the disposition has tax consequences for you. Depending on your asset types, you could have capital gains or losses, taxable income, business losses, or even capital cost allowance recapture, which is a tax on depreciated property.

Fortunately, the Canada Revenue Agency’s Income Tax Act offers an important relief provision for handling the disposition. Since you’re just changing the legal structure of your business, you aren’t really selling it. Tax legislation recognizes that your situation could lead to unfair results. With this in mind, the CRA lets you use a rollover, but you must expressly choose it by completing and filing Form T2057. Due to the complexity of the form and accompanying documentation, you may want to consult with a tax professional prior to your transition.

Owner Payment: Salary, Dividends, or Loans?

As a sole proprietor, the profits of your business serve as your personal income. When you form a corporation, you become a shareholder of a company. That gives you other means of paying yourself that may provide tax advantages. As a shareholder, you can pay yourself dividends from the company’s profits. You can also classify yourself as a company employee and pay yourself a salary. Before you make the decision, you need to figure out what works best for you and your family in terms of income regularity, contributions to registered retirement savings plans, and projections of your personal and corporate tax rates.

Alternatively, your incorporated small business can simply lend you money. Shareholders often take advances from the company paying little or no interest and with no reimbursement terms. You can do this legally so long as your company is solvent, but keep in mind that the Income Tax Act has provisions that transform these loans into dividends if you don’t repay them within two years. This ensures shareholders don’t simply lend themselves money and never pay taxes on it. For the first two years, though, you can give yourself a tax and liquidity break with this technique.

GST/HST Issues When Incorporating

When deciding if you should incorporate, consider how the goods and services tax and harmonized sales tax for the disposition of your sole proprietorship affects your new corporation. Since the CRA considers your corporation a different legal entity, you must register it for the GST/HST and all other CRA and provincial accounts. You can’t just use your old registration numbers. In fact, at the end of the process, you probably need to close your personal GST/HST account.

Further, the sale of your small business to the company counts as a taxable supply under the GST/HST rules. This means you should charge the GST/HST to your company and remit it to the government. Your company can claim an input tax credit for the amount paid, but it may take a few months before it receives the money, which may lead to cash flow problems. In light of this, you can make a special election that gives the supply a value of zero for GST/HST purposes. This ensures you have no tax payable. To make this election, you need to use Form GST44.

The trick to incorporating successfully is to take your time and document your transactions with easy-to-use accounting software, such as QuickBooks Online. When in doubt, don’t hesitate to contact the tax authorities and seek clarifications to make sure you understand your tax obligations. QuickBooks can also help you maximize your deductions at tax time. Keep more of what you earn today.

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