As your business grows, so does the scope of potential liabilities that may be associated with its continued operations. Operation as a sole proprietorship holds the distinct disadvantage of placing all liability of the business squarely on the shoulders of the business owner themselves in their personal capacity.
While some of this liability may well be covered off through the implementation of various insurance policies, this may quickly cease to be the case as the scale of the business and its related liabilities grows. At some point, any successful business owner will need to consider a limited liability form or structure in which there will be no personal liability, such as a corporation. The question of when the time is right to incorporate requires careful consideration of your personal situation and the particular needs of your business weighed in light of the advantages and disadvantages associated with incorporation.
Disadvantages of Business Incorporation
While technically you are able to incorporate on your own, it is advisable to seek the help of an accountant and/or a lawyer to do so. There are also annual fees associated with keeping a corporation in good standing. This obviously involves a certain degree of cost over and above those of maintaining a sole proprietorship and these costs may be prohibitive for younger businesses.
Incorporated entities must file more paperwork, such as separate tax returns, an annual return, one-time articles of incorporation and notifications of share sales, moves or changes of directors.
Ability to Claim Losses
If you run an incorporated business at a loss and then shut it down, you are unable to claim the business’s losses personally on your income tax return. The amount you are able to claim personally is limited to the amount of money you lent or invested in the business as stock or loans. With a sole proprietorship, you may be able to claim the full amount of your business losses against other income.
Advantages of Business Incorporation
Separate Legal Entity
The act of incorporating creates a new legal entity that is separate from the individual business owner called a corporation. Corporations formed under the various Canadian corporation statutes have all of the same rights and obligations as a natural person meaning they have the ability to do anything a natural person of full legal capacity can do. For example this would include entering into contracts, acquiring assets, entering into debt obligation, suing and being sued.
What is important is that a corporation is separate and distinct from its shareholders meaning its money and other assets belong to the corporation and not to its individual shareholders. When a business is incorporated, its separate legal status, property, rights and liabilities continue to exist until the corporation is dissolved, even if one or more shareholders or directors sell their shares, die or leave the corporation.
The shareholders who form the corporation are only required to contribute the amount that they have agreed to pay for their shares in the corporation. This creates what is referred to as limited liability for the shareholders as generally the shareholders are not responsible for the corporation’s debts.
For example, if a shareholder has been issued shares in a corporation for an aggregate of $100, then that shareholder’s liability for the corporation’s debts is limited to the $100 paid for those shares. The shareholder will not lose more than his or her initial investment in the corporation in the event that the corporation goes bankrupt, unless they have provided a separate personal guarantee for the corporation’s debts. Creditors also cannot sue shareholders for liabilities incurred by the corporation, even though shareholders are owners of the corporation.
Whereas a partnership or a sole proprietorship would cease to exist upon the death of an owner, a corporation is said to have potential immortality. As ownership of the corporation transfers to a shareholder’s heirs upon that shareholder’s death, a corporation may live on even if every shareholder or director was to die. This assurance of continuous existence provides a greater stability to a corporation which allows for strategic planning over a longer term to obtain more favorable financing.
The various tax advantages of incorporation are usually the driving factor behind the decision to do so. Corporations are taxed separately from their owners at a corporate tax rate that is most often lower than their individual tax rate.
Some corporations receive preferential income tax treatment (for example, the small business deduction) and corporations often provide more flexibility in deferring taxes and in allowing the division of business income.
If you are a director of a Corporation you may also be able to choose the most tax-efficient way to pay yourself either by way of dividends, salary, bonuses or a combination of each. You may even be able to use dividends as a way to split income with your spouse if he or she is a shareholder.
Access to Capital
Typically, it will be easier for a corporation to raise capital than for other forms of business. Where other forms of businesses must rely on owner funds or loans for capital, corporations have the ability to issue of bonds or share certificates to investors in order to raise additional funds. What is more, as financial institutions often view loans to corporations as being more secure, corporations typically have the ability to borrow money at lower interest rates.
The question of should your business incorporate is often more a question of when than a question of if. If you are considering whether or not the time is right to incorporate, you should contact a corporate lawyer for further information.