Canadian law has recognized the concept that a corporation has a separate identity even where you have a one person corporation. A corporation is a legal person separate from its shareholders, employees and directors.
If you are considering incorporating your business, the following are the main advantages of incorporating:
The main advantage to incorporating is the limited liability to the shareholders of the company.
If you operate a business as a sole proprietorship, or in partnership with others, the individuals assume all the liabilities of the business. When a business becomes incorporated, an individual’s shareholders liability is limited to the amount he or she has invested in the company. If a sole proprietor or a partner, your personal assets such as your house and car can be seized to pay any debts of the business.
As a shareholder of a corporation, you cannot be held responsible for the debts of the corporation, however, any financing you require for the operation of the company may require a personal guarantee, which re-instates the personal liability.
Also, a director of a company does have some personal liability with respect to employee withholding tax, wages to employees for work performed to a maximum of six months, vacation pay which has accrued to a maximum of twelve months, and HST. There also may be some personal liability to a director if reasonable care is not taken with respect to any environmental problems caused by the company.
You should review carefully your tax situation with your tax advisor prior to incorporating. There are tax advantages to having a corporation once a certain income level is obtained since the income of the corporation can be disbursed by a combination of bonuses, salaries and dividends.
If you are just starting a business, it may be more beneficial to wait until such time as the business has a positive cash flow before incorporating in order that any initial losses may be applied against other personal income.
If you incorporate a small business, you can determine when you personally receive income, which may be a tax advantage. Instead of getting your income when received, the incorporation allows you to take your income at a time when you pay less in tax.
A corporation also allows income splitting between various members of your family. It is possible to have different classes of shares held by different members of your family and income can be distributed by dividends on the various classes of shares in order that monies can be disbursed to shareholders at a lower tax bracket.
A shareholder does not have to be actively involved in the business in order to obtain income by way of dividends.
THE SMALL BUSINESS TAX DEDUCTION
If you incorporate your small business, the corporation may qualify for the small business tax deduction if the company is carrying on an active business, as defined in the /ncome Tax Act. The small business deduction permits a lower tax rate on the first $500,000.00 of active business income, which may be a much lower tax rate than what you are paying with respect to your personal income.
This small business deduction will allow you to retain money in the corporation at a much lower tax rate. Since less taxes are being paid, as long as the money remains in the corporation, more funds are available for re-investment in the business.
CORPORATIONS CARRY ON
Another advantage of incorporating is continuance. Unlike a sole proprietor or a partnership, a corporation has an unlimited life span. The corporation will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes.
Choose the proper name for your corporation. You want to have a unique name which will represent your company and the product that you are selling. The name of the corporation ends with either “Limited”, “Ltd.”, “Incorporated”, “Inc.” or “Corporation”. Any one of these forms can be used, however, the more popular designation is “Incorporated” or “Inc.”.
Prior to filing your articles of incorporation, it is necessary to complete a MANUALLY UPDATED AUTOMATED NAME SEARCH (NUANS) in order to determine if your proposed name conflicts with an existing business. The Companies Branch will not refuse a name that you choose, however, if it does conflict with another company, you may be forced by that company to change your name to a dissimilar name. It is therefore important that you choose the name carefully since you do not want to incur the cost of changing your name and re-branding your business.
Although there are many advantages to incorporating a business, there are also some disadvantages which must be taken into consideration.
1. Another Tax Return
If you incorporate your business, you will have two tax returns to file in each year – your personal income tax return and the one for the corporation. This will be mean increased accounting fees and additional bookkeeping.
2. Increased Paper Work
There is paper work involved in order to maintain your corporation. The corporation must maintain a minute book, which contains the by-laws for the company and the various resolutions with respect to the organization of the company, and on-going annual minutes. Any changes in the corporation must be filed with the Companies Branch.
3. Tax Considerations
As previously stated, initially if the company is going to sustain a loss, it may be better to incorporate at a later date in order that the loss may be applied against other income.
4. Limited Liability
One of the main reasons for incorporating is to have the advantage of limited liability in order that your personal assets are not a risk. However, as a practical matter, this is of no value when you have to give a personal guarantee in order to obtain financing for the operation of the business.
5. Start-Up Costs
To incorporate a company it involves legal fees, government fees and accounting fees. The company is a more complex structure than a sole proprietorship or a partnership.
If there are a number of shareholders in the company, it is imperative that a shareholders agreement be prepared, which at a minimum would have procedures available to deal with the following events:
- if a shareholder dies, are the other shareholders required to purchase his or her shares, and if so, is the purchase to be funded by life insurance;
- if there are a number of shareholders, it is necessary to protect the minority shareholders from a majority shareholder having the ability to make decisions on his or her own, which may be to the detriment of the minority shareholder;
- in the event of a disagreement, an exit strategy is necessary, otherwise the feuding shareholders could prevent the company from operating in the usual course of business. A common exit strategy is known as “a shot-gun agreement” whereby if a shareholder wishes to exit the company, an offer is made to the other shareholder to either sell or buy the shares at a fixed price. The person who initiates the “shot-gun” must be prepared to buy or sell shares at the determined price.
This article is merely an overview of what should be considered prior to making the decision to incorporate your business.
Before proceeding, it is imperative that you review all these matters with your legal advisor and your tax advisor. For more information about our Corporate Law services.