When Should a Small Business Consider Incorporating?

Sole proprietor vs. corporation: the basic difference

As a sole proprietor, you and your business are the same for tax purposes. All business profit is added to your personal income and taxed at your personal rates in the year it's earned, whether you spend it or leave it in the business account.

A corporation is a separate legal and tax entity. It pays corporate tax on its profits, and you pay personal tax only on what you take out as salary or dividends. That separation is the source of most of the benefits and most of the extra work.

The main reason to incorporate: tax deferral

Active business income earned by a Canadian-controlled private corporation can qualify for the small business deduction, which taxes that income at a much lower combined federal and Alberta rate than top personal rates. If you leave profits in the corporation, you defer personal tax until you take the money out.

That is a deferral, not a permanent saving. When the money is eventually paid out, personal tax applies. The benefit is having more after-tax money available inside the business to reinvest, pay down debt or invest, sometimes for many years.

This is why the most common signal is simple: is the business earning more than you need to spend personally? If you need every dollar of profit to live on, incorporation offers much less tax benefit, because the money comes out right away and is taxed personally anyway.

Other potential benefits

• Limited liability. A corporation can limit your personal exposure to business debts and claims, although lenders often ask for personal guarantees and professionals may remain personally liable for their own work.
• Flexibility in how you're paid. You can choose a mix of salary and dividends. See Salary vs. Dividends for Canadian Business Owners.
• Lifetime capital gains exemption. Shares of a qualifying small business corporation may be eligible for the exemption on sale, which can be valuable if you plan to sell one day.
• Continuity and credibility. Some clients, suppliers and lenders prefer to deal with a corporation.
• Access to programs. Some incentives, such as the enhanced refundable SR&ED tax credit and Alberta's Innovation Employment Grant, are designed for corporations.

The costs and trade-offs

• Setup and ongoing costs. Incorporation, annual registry filings, a minute book, and corporate year-end accounting and tax returns all cost more than a sole proprietorship.
• Two tax returns. You'll file a corporate T2 and Alberta AT1 every year, plus your personal return. See What Happens at a Corporate Year-End in Alberta?
• Losses stay in the corporation. Early-year business losses generally can't be deducted against your other personal income.
• More rules. Shareholder loans, personal use of company assets, tax on split income (TOSI) and passive investment income all have rules that can create unexpected tax if they're not managed.
• Getting money out takes planning. The money in the corporation isn't personal money until it's paid out properly.

Signs it may be time to look at incorporation

• Your business consistently earns more than you need to live on
• You expect steady or growing profits for several years
• You want to reinvest in the business, such as equipment, staff or growth
• You have meaningful business liability risk
• You plan to sell the business one day
• You're doing R&D and want access to corporate incentives

Signs it may be too early

• Profits are modest or uncertain
• You need all the income for personal living costs
• You expect losses in the next year or two
• The business is a short-term or side venture

Moving an existing business into a corporation

If you're already operating as a sole proprietor, assets such as equipment and goodwill can often be transferred to a new corporation on a tax-deferred basis using a section 85 rollover. This must be done correctly and on time, so plan it with your accountant before you incorporate.

Common questions

This article is general information only and is not tax, legal or accounting advice for your specific situation. Refer to the Canada Revenue Agency and Government of Alberta's Starting a business page for current requirements.