Incorporation
“I am starting a business, should I incorporate it?”
This is a common question we get from new business owners. Two of the main reasons to incorporate a business is to save income tax and to reduce the operator’s personal liability for the business’ debts.
Incorporating For Income Tax Reasons
From an income tax perspective, it is important to understand how a corporation is taxed when compared with an individual. The Federal Government has taken steps to try to eliminate tax loopholes, but some of them are there to be used with proper advice.
When an individual earns a dollar, they pay a portion of that dollar in tax, dependent on their marginal tax rate. How a corporation earns a dollar and then pays tax on that dollar is a complicated analysis of paying salaries and bonuses out of before-tax money and paying dividends out of after-tax money, each of which has its own tax consequence when received by the operator. There are some mechanisms available for businesses to minimize income tax using corporations, but they depend on meeting specific criteria.
It is important to discuss the tax mechanisms available with your accountant prior to commencing business to ensure that you understand the tax consequences of your decision.
Incorporating to Avoid Liability
From a liability standpoint, an individual is personally liable for the debts of the business they carry on, while a corporation is liable for such debt but the underlying shareholder/operator is not. This is usually the primary attraction to using a corporation to carry on business. On a practical note, some of the entities that a corporation frequently deals with such as its trade creditors, landlord, and its banker will usually ensure that the debts owed to them are secured by the personal guarantees of the corporation’s shareholders, which results in reducing the liability shield. However, these are usually risks which an operator is prepared to accept as a price of doing business. The corporate shield will protect the operator from unexpected liabilities such as damage or injury that results from the product or service being defective.
It does cost money to incorporate a business, maintain its corporate records and file its income tax returns, and sometimes the operator wishes to see if their business succeeds first. A business can be converted into a corporation later, using special elections available to avoid income taxes triggered upon that transfer, but this involves further consultation with an accountant and a lawyer and slightly higher costs than starting the business as a corporation.
Before you make a decision to incorporate or to do business personally, weigh the income tax consequences in consultation with your accountant, and decide whether there are significant liability risks to the type of business. If either of these questions indicates advantages to incorporating, then you should not be conducting business personally.
It should be noted that the impact of the law on any given situation depends upon each individual’s circumstances and the opinions contained in this article should not be relied on for assessing anyone’s legal position. Advice should be obtained directly from our business law lawyers regarding your particular situation.
If you have any further questions, please contact us at Doak Shirreff lawyers. We have your best interests in mind and would be happy to help.