When to Incorporate Your Business: Evaluating Benefits, Taxes, and Investing Considerations
If you’re a small business owner or professional such as a doctor, you might be wondering: What are the benefits of a corporation? And, when should I incorporate my business?
Incorporating a business can be a good choice because it provides a number of benefits, including tax advantages and liability protection.
But it can also be a complex and expensive process and isn’t necessary for every business owner to do.
So, to demystify when to incorporate your business and the benefits of doing so, I spoke with Mark McGrath CFP®, CIM®, CLU® on episode 70 of The Canadian Money Roadmap podcast.
Mark works as a wealth advisor at Wellington-Altus Private Wealth. Working with mostly high-income professionals, Mark is an expert in financial planning for small business owners. Here are some of his insights into when to incorporate your business and the benefits of doing so.
What is a Corporation?
Many people think of large companies like McDonald’s, Nike, Apple, or similar when they think of a corporation.
But that’s not what we’re talking about here. A corporation can take on many different forms, big or small. Here we’re discussing corporations for small businesses or professionals like doctors, engineers, or physiotherapists.
Simply, a corporation is a distinct legal and tax entity.
Many professionals or businesses operate as sole proprietors, where the owner is effectively the business. All of the income earned or expenses paid by the business go through the owner’s personal tax return.
Corporations separate the business from the individual so that they are separate and distinct entities.
Within this separate legal structure, corporations can take on a number of different formats. You may be the sole shareholder as the owner, or there may be a number of shareholders that run and operate the business.
Benefits of Incorporation
Setting up a corporation separates you as a person from the business itself. There are two major benefits to doing this: liability and taxes.
Liability Implications for Corporations
Things can go wrong with even the most careful and prudent business owners.
If you are operating under a sole proprietorship, you are your business, so you’re personally liable for accidents, injury, or other incidents.
But if something happens within a corporation, it’s only the business that’s sued, not the individual owner. The business may face legal or financial repercussions, but the owner’s personal assets can’t be touched.
This is particularly important for companies and businesses that are innately high-liability. Just think of anything in customer service, anything outdoors, or the food services industry—lots of potential for accidents, injuries, or illness.
Protecting your personal assets and removing personal liability from the equation is an important benefit of corporations.
Tax Implications for Corporations
The second major benefit of incorporating your business has to do with taxation, primarily in the form of tax deferral.
Say your business is earning a good chunk of profit, say $750,000 as an example—more than you need as personally to live on. If you had to take all of that as personal income, you’d be paying very high taxes on that money.
But with a corporation, you can pay yourself a salary that meets your and your family's needs and leave the rest in the company.
By doing so, you are deferring tax on those profits into the future, where you can take it at another time you need it such as retirement.
Misconceptions About Taxation and Corporations
When we talk about tax benefits for corporations, many people associate it with companies “not paying their fair share.” But this is typically based on misconceptions about corporate taxation.
The CRA (Canada Revenue Agency) operates on the mechanism of integration, which ensures that individuals are roughly paying the same amount of tax by the time money hits their personal wallet.
For example, one way that shareholders of a company can pay themselves is through dividends, which can be either eligible or ineligible. The dividends are taxed at both the company and individual levels.
Without getting into all the details of how it works, eligible dividends are taxed at a higher general rate in the corporation but lower to you. And, therefore, ineligible dividends, are taxed lower in the corporation and higher to you personally.
So, the end game is roughly the same. The CRA has a number of other mechanisms to ensure that whether you’re a shareholder, sole proprietor, or employee of a company, individuals in Canada pay roughly the same taxes.
The other big misconception around corporations is that there is massive financial gain in the form of business expense write-offs. Some people think that by “writing it off,” they’re getting something for free.
In reality, a legitimate business expense eligible for write-off just means that you do not pay all or some of the taxes on that item—you still need to spend the money! So tax write-offs do provide some benefits, but it’s not a get-rich-quick mechanism.
Earning Income Through a Corporation
One complex aspect of incorporating your business is how you’ll actually earn a paycheque. Mark shed some light on the two main mechanisms to take money out of your business and into your back pocket:
Salary: Salaries taken by shareholders are fully deductible to the company and fully taxable to the individual. Just like working as an employee, you pay taxes and make CPP contributions.
Dividends: Dividends are considered “unearned income” and act kind of like investment income. These are not deducted from the company, so the company pays taxes on them before it goes into your personal wallet, where it is taxed again to a lesser proportion.
Because of integration, the net result is that you will pay roughly the same taxes with both methods.
Each province has different tax rates and, because of that, there may be slight advantages to receiving dividends. However, the downside to this approach is that you are not paying into CPP to have that security in the future nor are you earning RRSP contribution room.
Many people choose a combination of both mechanisms as a way to keep their CPP and RRSP contributions via a salary while getting a slight benefit from taking dividends.
As you can see, it’s a complex process—all the more reason to work closely with an accountant to figure it all out.
When to Incorporate Your Business
Incorporation can be complex and, because of that, will cost your business more money. Mark strongly recommends working with a team of professionals, including a lawyer to set up your corporation, an accountant to handle your taxes, and a financial advisor to help you with your investments.
Working with these professionals is key to your success, but it’s not cheap. Be prepared to incur an accounting bill of at least a few thousand dollars a year.
For this reason, incorporation should really only happen when you’re earning enough money to justify the bill. Many high-earning professionals like doctors, dentists, veterinarians, or lawyers are well-positioned to incorporate so they can receive some of the tax benefits of doing so.
The other key reason when to incorporate your business is when you need liability protection. If your business has some inherent risks or opportunities for disgruntled customers, you may consider protecting yourself through incorporation.
We’re truly just covering the tip of the iceberg of everything Mark had to share on the podcast about when to incorporate your business and the benefits of doing so.
Make sure to catch up and listen to episode 70 of The Canadian Money Roadmap podcast, or follow along with Mark on LinkedIn or through Wellington-Altus Private Wealth.