To minimize costs and test the economic waters, many Canadians start their own business as a sole proprietorship. If your business proves successful, you are then faced with the decision of whether or not to incorporate.
Let’s take a look at the income tax and operational business concerns you must consider before making the decision to move from a sole proprietorship to a corporate structure.
Tax and Profitability
As a sole proprietor, you must report your business income on your personal income tax return. As such, your profits are taxed at your marginal income tax rate.
If you require all your business profits to fund your lifestyle; it does not make financial sense to incorporate your business. However, if your business has become profitable enough that you do not need all the income generated for day to day living, incorporation begins to make some sense as a tax deferral mechanism.
As a business grows, often so too do the risks and potential legal hazards involved.
In a tangible goods business, volume of sales tends to increase, and consulting activities become more complex.
Consequently, the risk of a product flaw or manufacturing error increases. As a proprietor, any legal action taken against your business places all your personal assets at risk, including your home (if it is in your name). Therefore, the decision to incorporate often makes sense just to ensure your personal assets are protected.
Until you incorporate, it is vital to ensure you maintain adequate business insurance and minimize the assets held in your own name.
Capital Gains Exemption
One of the main advantages of incorporating is potentially being able to access the capital gains exemption for qualified small business corporation shares.
Shares of a qualified small business corporation (QSBC) qualify for a capital gains deduction and in order to qualify as a QSBC, a company must be a Canadian controlled private corporation with at least 90% of its assets being used in an active business in Canada.
The exemption makes it possible that a husband and wife who are 50/50 shareholders in a private corporation could sell their business and not pay any income tax, subject to a number of complex criteria.
The criteria to determine whether shares qualify for the capital gains exemption are very complicated, and specialised tax planning is imperative to ensure you qualify for the capital gains exemption.
Income splitting used to offer an opportunity for substantial tax savings to private corporations and their shareholders. However, the new rules that have come into effect now place heavy compliance burdens on small businesses. To learn more about how the new income splitting rules affect small business owners, read our blog dedicated to this topic here.
How Do I Go from a Sole Proprietorship to a Corporation?
It is important to note that the below is a basic overview of the process and there are several complex rules that come into play when transferring a sole proprietorship to a corporation as well as when considering the inclusion of any family members in the new corporation.
It is crucial to understand the ramifications of the decisions involved and obtaining proper income tax and legal advice from an experienced professional is highly recommended.
There are specific requirements that allow for you to transfer your sole proprietorship to a corporation on a tax-free basis – shares of the corporation must be received on the transfer. Although this is a standard transfer provision, it is fraught with landmines.
The combined legal and accounting fees to undertake this transaction can be quite depending upon the complexity of the transfer. It is for this reason that many people decide to forgo this step, especially when they consider their main business asset to be personal goodwill (your client base continues to support you because of their relationship with you, without you the business is worthless) as opposed to business goodwill (the value of your business name, customer list, intellectual property etc).
Skipping this step is often a risky decision. This is because when you transfer your assets and goodwill from your proprietorship to a corporation, you are deemed to have sold or disposed of these assets at their fair market value. Filing the tax-free rollover is a valuable move in order to avoid this deemed sale and to ensure you do not create any income or capital gains upon the transfer of these assets.
Once you have decided to rollover your goodwill to the corporation, it needs to be valued, which can be a costly exercise. If all the shares of the corporation are issued to one person, your estimate of the value of the goodwill may be accepted, if it is realistic and supportable. However, where other family members will become shareholders, a professional valuation is required.
The income tax benefits of a corporation can be significant. However, the transfer of a sole proprietorship to a corporation is very complex, especially when introducing family members as shareholders. It is thus vital that you engage a financial and tax specialist to explain all the income tax and legal issues to you before undertaking the transfer.