When your company operates in an industry that's often the subject of lawsuits, taking extra steps to protect your business and personal assets is a smart move for small business owners.
That’s why Steve Hamelin, an architectural designer in Oakville, Ont., chose to incorporate his business, Hamelin Arch Inc., in 2013.
“Working in construction, I got worried that if I were to make a mistake, or one of my employees were to make a mistake and I got sued, I didn’t want [litigants] to be able to come after my house,” says Mr. Hamelin, whose company operates under the name Steve Hamelin Design Studio. “I wanted to protect my family.”
Mr. Hamelin, who has employed up to eight designers at various points since his company’s inception in 2006, paid about $1,500 in legal and accounting fees to incorporate his business and shells out several thousands of dollars more each year to maintain the corporation.
Legal and accounting fees typically run anywhere from $2,000 to $6,000 or more a year, depending on the complexity of a corporation’s structure, such as whether it involves a family trust or a holding company.
If not for the potential to minimize liability exposure, Mr. Hamelin probably wouldn’t go the incorporation route again.
“I find I’m paying more [in fees],” he says. “It’s not saving me anything because I don’t keep money in the corporation. And it’s much more complicated [to maintain].”
Mr. Hamelin estimates that he spends the equivalent of a month of business hours each year tending to his corporation in various ways, from bookkeeping to financial reporting.
Indeed, while incorporation can deliver huge tax savings for small business owners, it can also be a heavy administrative burden – particularly for individuals with lots of personal expenses or limited revenue.
Factor in the federal government’s recent changes to passive income investment rules – which limit the investment income that can be accrued within a corporation – and the decision of whether or not to incorporate is far less cut and dried for small business owners than in the past.
In other words, the potentially life-changing decision to incorporate is one that needs to be weighed carefully and assessed with a view to an entrepreneur’s long-term personal and business financial goals.
But when the circumstances are right, the potential financial benefits of incorporation are undeniable.
If a client’s business isn’t exposed to major legal risk, John Swain, president of Bridgewater, N.S.-based accounting firm Swain Chartered Professional Accountants Inc., steers the conversation back to the question of cash-flow requirements.
“Generally, if you don’t need to take the money out to live personally, leaving it in the corporation means you only have to say goodbye to a pretty small amount of tax to the government,” he says. “Then you can have those funds available to retain in your business and help grow and hopefully make it more profitable.”
Leaving profit inside a corporation allows a business owner to accumulate wealth in their company faster than if they were to take it out right away. It defers taxation on that income and taxes it at a lower corporate rate, at least initially.
In Alberta, for example – where the combined federal-provincial corporate tax rate for active business income generated by a Canadian-controlled private corporation claiming the small-business deduction is 11 per cent on the first $500,000 of taxable income – a company that generates $100,000 in revenue this year would be left with $89,000 to reinvest in the business.
In contrast, drawing that revenue from the corporation would generate a tax bill of between 25 per cent and 30 per cent, depending on various factors.
“You need to let professionals process those profits and try to reduce tax as much as possible,” Mr. Swain says, adding nevertheless that tax decisions shouldn’t dictate a company’s strategic direction. “Never let tax be the tail that wags the dog.”
Pawel Biedacha, an accountant with Geib & Co. Professional Corp. in Calgary, says that incorporation offers benefits that extend far beyond tax deferrals.
For example, entrepreneurs planning an eventual exit from their business can use their corporation to leverage tax mechanisms such as the lifetime capital gains exemption – set at $866,912 in 2019 on qualifying small-business-corporation shares – to receive that portion of the sale of their shares tax-free.
Incorporation also provides entrepreneurs with flexibility and control over how they pay themselves.
Incorporated business owners can choose whether to pay themselves a salary, which requires them to pay into the Canada Pension Plan, but guarantees a retirement income and also creates RRSP contribution room. The other option is to pay themselves through dividends, which is after-tax corporate income paid to the business owner at a lower tax rate.
But what about new federal tax rules that have caused so much consternation across the business community?
As Mr. Biedacha explains, under the amended rules an incorporated business that earns more than $50,000 in investment income will now gradually lose its small-business deduction.
For every $1 of investment income earned within the corporation over the allowed threshold, the small business loses $5 of small-business deduction limit. When the corporation earns $150,000 of investment income, the small-business deduction is gone.
In that scenario – using Alberta rates as an example – a corporation earning more than $150,000 of investment income would no longer be taxed at the preferred rate of 11 per cent, but at the general corporate rate of 27 per cent.
“For existing businesses that have built up investment portfolios in a corporation, they are very affected,” Mr. Biedacha says of the changes.
“But for new businesses, I don’t think any would have a $50,000 portfolio, so they would still get the benefits of incorporation. But you need to do some tax planning around accumulating passive assets or investments in your company to avoid losing the small business deduction in future.”
Mr. Hamelin of Steve Hamelin Design Studio advises fellow business owners to do their homework and think carefully before incorporating.
“Make sure you have a very good accountant who understands the differences between moving from being a sole proprietor to running a corporation,” Mr. Hamelin says.
“The taxes are different, the money you need to save to pay back those taxes is different. If you’re set up the right way, there’s no reason why you can’t be really successful. I wasn’t really educated enough when I did it, and that was a problem for a little while. I got behind and there were things I didn’t know I had to pay. It was an accounting nightmare.”