For many entrepreneurs, a key decision when establishing and growing their business is what legal form the business should adopt. The most common structure adopted for most entrepreneurs at the outset of their business venture is a simple sole proprietorship, essentially personal ownership of the business. However, as a business starts to grow, deciding whether or not to incorporate the business (the process of forming a legal corporation) becomes a hot topic. That being the case, many ask themselves when the right time to incorporate is and what the pros and cons of incorporation are?
The following are some key considerations when deciding to incorporate a business:
- Limiting Liability
When a business is operated as a sole proprietorship, the owner of the business is operating in their personal capacity and incurs the debts or other liabilities of the business personally. This means that if the business becomes liable to anyone, the personal assets of the owners are at risk. However, once incorporated, the corporation and not the individual owners incur liability. As such, incorporating serves as one way that an entrepreneur can protect their own assets from claims made by clients, contractors, landlords, employees, and creditors. In essence, a corporation can serve as a shield for its shareholders.
A corporation is a person in the eyes of the law, and as such, is treated as separate from its shareholders for the purpose of assessing income tax. Further, assuming certain criteria are met (which most small and medium sized businesses meet), corporations are taxed at a combined federal and provincial tax rate in Saskatchewan of only 11% on their first $500,000 of income, 17% between $500,000 and $600,000, and 27% on income over $600,000. Compare this to income taxes paid by a business operating as a sole proprietorship of 25.5% up to $45,225 in income and ranging up to 47.5% on income earned over $214,368. This being the case, incorporating a business allows for a large deferral of income tax which can help in financing and expanding the business.
In addition to paying less taxes while operating the business, there are also potential tax advantages when it comes time to wind down the business or sell it. In particular, a sale of a corporation can allow access to an individual’s lifetime capital gains exemption (“LCGE”) on the sale of shares of the business, something that is simply not possible for an unincorporated business. As of 2020, the LCGE allows $883,384 of capital gains on qualifying shares to not be taxed, providing tax savings of up to $209,804 for an individual in Saskatchewan when they sell their business.
However, there is one downside to incorporating a business from a tax perspective in that a corporation traps any business losses suffered inside of the corporation. The downside to this is that if this business were operated as a sole proprietorship, the individual could use such losses to reduce the amount of tax owed on other income they have earned. This is something to particularly consider if it is forecasted that the business will not be profitable for a period of time.
- Establish Clear Ownership
If there are multiple owners of the business, incorporating can help make it clear who exactly owns the business. This is because the owners are all issued a certain number of shares in the corporation which makes it clear as to who owns what portion of the business. This clarity can help in ensuring that everyone’s expectations are met in terms of who controls the business and who owns the value created by the business. Further, as new partners enter or exit the business, a corporation can help facilitate this as only the shares of the business need to be sold or transferred as opposed to stakes in all the individual assets of the business if incorporation has not occurred.
Incorporating a business can give a sense of legitimacy. Although somewhat vain, having the Ltd., Inc., or Corp. at the end of a business name can help demonstrate the legitimacy of the business. This is something to consider when trying to attract new clients and building a brand.
- Costs and Complexity
Aside from the restriction on utilizing business losses (discussed above), the only true downsides to incorporating a business are that 1) a corporation is more expensive to establish and maintain and 2) a corporation can be seen as somewhat more complex than personal ownership. The reason a corporation is more expensive is that there are legal fees and filling costs to establish the corporation and to maintain its status on an annual basis. Further, a corporation must file its own tax returns, so there may be more accounting fees payable where a corporation exists. In addition, a corporation needs to maintain certain records and comply with corporate regulations which can make operating a corporation mildly more complex, although lawyers and accountants can generally manage these aspects for relatively little cost.
With all of the above in mind, although there is nothing wrong with operating as a sole proprietorship, if it is believed that eventually the business should be incorporated, incorporating sooner rather than later will generally reap greater benefits. This is because in general the tax relief and limited liability provided by incorporation will be more valuable than the costs incurred to establish and maintain the corporation. Further, incorporating the business early allows for all of the initial set up of the business to be done in the corporate name so that this does not need to be redone at a later date.
If you are considering incorporating or altering the legal form of an existing or potential new business, our dedicated team of commercial lawyers would be happy to assist and answer any questions you may have.
STEVENSON HOOD THORNTON BEAUBIER LLP
500 – 123 2nd Avenue South, Saskatoon, SK S7K 7E6
The information in this guide is not legal advice. We encourage you
to consult with your legal advisor for specific advice.