A major question front of new business owners’ minds is if they should incorporate a new business or start as a proprietorship. Equally common is the consideration of those who already own a business that was started as a proprietorship – when is the right time to convert a proprietorship into a corporation?
Let’s take a look at the major factors to consider.
The Benefits of a Corporation
The above can be divided into two categories, tax benefits and non-tax benefits.
Tax benefits include the following:
The Lifetime Capital Gains Exemption
This benefit applies when it comes to the sale of your business.
On the sale of the shares of a Qualifying Small Business Corporation, each shareholder may be entitled to a $848,252 (as at 2018) capital gains exemption, this means that every shareholder’ gains of up to $848,252 may be completely exempt from tax.
If for example you, your spouse and your two children are shareholders of the family business you could potentially sell your business for over $3,000,000 tax-free.
If you think that your business has considerable growth potential and may be a sought-after acquisition target in the future, it is usually wise to incorporate.
Income Tax Rate
Since the personal rate on income can be substantially more than the tax rate applied to active business income, income earned within a corporation potentially provides a very large income tax deferral.
This is only the case though when you do not require all of the funds generated by the corporation to cover living expenses.
The potential +-30% deferral of income tax allows you to build your business with pre-tax earnings. It should however be noted that, in most instances, once you withdraw the money from the corporation, you essentially pay the deferred +-30% tax as a dividend.
The top non-tax reason to incorporate a business is for creditor proofing. Generally, a corporation provides creditor protection to its shareholder(s) through its limited liability status, which is not available to a proprietorship.
This protection becomes important in the instance that a corporation is sued and becomes liable for a successful claim. In this case the only assets exposed to the creditors are the corporate assets, not the shareholders’ personal assets.
An important factor to consider when starting a business is whether your area of business comes with a naturally high risk of litigation. If so, it may be wise to incorporate from the beginning.
Can I convert from a proprietorship into a corporation?
Where you start your business as a proprietorship, it is still possible to convert the proprietorship into a corporation on a tax-free basis and to take advantage of the capital gains exemption going forward.
However, there are a number of points to take into consideration.
One: Incorporating a proprietorship after the business has been operating for a few years may result in substantial legal, accounting and valuation fees
Two: Assuming you plan to include other family members as shareholders in the new corporation, the value of the business at the time of incorporation will belong to you and needs to be reflected in special shares that must be issued to you.
Things to note: misconceptions about corporations.
Many people want to incorporate their business because they feel they will qualify to deduct far more expenses from their profits in a corporation than a proprietorship. In a general, that is an income tax misconception. For all intents and purposes, the deductions allowed in a proprietorship are virtually identical to the deductions permitted in a corporation.
The costs involved in maintaining a corporation are significantly larger than that of a proprietorship. There are initial and ongoing legal costs and annual accounting fees to prepare financial statements and file corporate income tax returns. These costs can be significant in some cases and can even outweigh some of the tax benefits in certain situations.
Why Start as a Proprietorship?
If you do not have legal liability concerns, starting as a proprietorship keeps your costs down and reduces your compliance and administrative issues.
The biggest factor to take into account is that most people need to make use of all the cash their business generates in its early years to cover living expenses which means that there is little to no tax benefit from incorporating a business initially.
When to Incorporate your Proprietorship
Once the business has established some roots, has proven to be a viable business and has begun to generate income in excess of your living expenses, you can consider incorporating your proprietorship.
The major motivation would be so that you can take advantage of the +-30% tax deferral available in a corporation so make sure that the earnings are exceeding your living expenses by quite a decent sum to make this a worthwhile option.
In closing: Each business is unique and there is no blanket answer when it comes to determining whether to incorporate a new or ongoing business. These key topics to consider will go a long way in helping you see considerations in a clearer manner, but it is always advisable to consult with tax professionals when making the final decision that could impact your business and earnings in the long term.