When Should a Sole Proprietor Incorporate?

There are many advantages and disadvantages of incorporating a business owned and operated by a sole proprietor – however a corporation may provide that added layer of protection and tax planning that a successfully run business would be ready for. The question most entrepreneurs ponder is not whether to incorporate, but when is it optimal to do so. It is important to note that there is no all-encompassing answer to this question. The timing of and need for incorporation is unique for each business.

The main advantages to incorporating a business include a limitation of liability, access to lower tax rates and income splitting. With limited liability, the owners of the business are a separate entity from the corporation. They have a layer of protection from being held personally responsible for mistakes made by the business entity. The owners are also no longer liable for the debts of the business.

If a business qualifies for the Small Business Deduction, the first $500,000 of active business income is taxed at a combined federal and Alberta rate of 11%. The lower tax rate applies to the extent money is left in the corporation. Dividends from the remaining funds are only taxed when taken by the shareholders. A sole proprietor does not have the ability to defer tax in this way as income earned by a sole proprietor is taxed at the individual taxpayer’s personal tax rate. This ranges from 25% to 48% in Alberta.

The dividend can be timed to be taken in a lower income year or distributed to various family members who are shareholders – to utilize their lower tax rate. This not only results in tax deferrals, but also tax savings. Because of different tax rates, tax savings can also be achieved through control of income received by having an efficient mix of dividends, salary and bonus paid to the owner manager. With a corporation there is greater opportunity to minimize taxes through income splitting techniques with family members that may be involved in the business in both an active or passive capacity.

Owners of Qualified Small Business Corporation Shares may also enjoy the life time Capital Gains Exemption of $800,000 (plus inflation since 2014) on the sale of those shares.

Because corporations have a perpetual life span, there are often other unexpected advantages including increased business, enhanced access to financing, better business image and protection of name or brand. However, incorporation also brings with it more regulation, more record keeping and paper work, more reporting to government and other statutory authorities and ultimately, more cost. Ultimately, all of the benefits should exceed the costs when deciding to incorporate a sole proprietorship.

As there can be additional fees and filing requirements associated with incorporation, the individual circumstances of a proprietor need to be carefully ascertained before incorporation becomes advisable. It is vital to seek professional advice when addressing this question.

Generally, a business that is in its start-up phase and is experiencing losses or earning nominal amounts of income may not be a good candidate for incorporation. This considers that an unincorporated proprietor can claim business losses personally against other sources of income and generate a personal tax refund or reduction of personal tax payable. Often this helps businesses to sustain themselves in the start-up period. Alternatively, losses incurred by a corporation can only be deducted against income earned from other sources by the corporation. Another reason is that an unincorporated proprietor can claim personal tax credits against his or her income and otherwise be subject to relatively low rates of tax on nominal income amounts.

To determine if incorporating is right for you, talk to your accountant.

This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. © 2021 Shajani LLP.

Shajani LLP is a CPA Calgary, Edmonton and Red Deer firm and provides Accountant, Bookkeeping, Tax Advice and Tax Planning services.