Should I incorporate my business? When it makes sense for taxes

There are so many different ways to start a business. Sometimes, it starts with a hobby that grows into an income. Sometimes it’s a well laid-out business plan that gets slowly put into motion. And other times, it’s an established business that is purchased or inherited.

Whichever path you might choose, most small business owners will ask themselves at some point whether it makes sense to incorporate.  So what are the Canadian tax advantages to incorporating your business and when does it makes sense to do it? Here’s what I look for when I’m advising clients on this very question:

Signs you should incorporate (when you’ll save tax):

 

  • You’re making more money than you need to use personally. The main tax advantage you get from incorporating is a significantly lower tax rate (often 11%) on your business income; but you only get this on money that you leave in the corporation. So if you need it all of your earnings to pay personal expenses each year then it’s probably not time yet.
  • You are reinvesting significant cash into business growth or equipment. There is a significant tax rate advantage here, because investments into capital items such as equipment require that money to be taxed first, and then deducted later. If your business is not incorporated, the tax rate on that initial investment is whatever your personal tax rate is at the time (usually in the 20% – 40% range), but if you are incorporated then that tax rate is likely going to be 11%. That’s a major savings!
  • Income splitting flexibility with other family members. While it used to be the case that you could easily split income from a corporation with anyone in your family, the rules have changed and those family members now have to be working in the business, at least to some extent. However, there are still some other advantages if you’re planning to sell your business eventually.
  • You have other income personally and are already in a high tax bracket. This is often the case if you’re starting a side-hustle and you are still employed full-time, or if you’re starting a second business. Without incorporating, you’re likely to face a high tax bill on your business income

Signs to wait for incorporation:

 

  • All the money you make you need to spend personally. (see above!)
  • You’re not making enough to justify the administrative cost of having a company. Aside from the legal costs of incorporating, which can often be in the $1,500- $3,500 range initially, you will be required to file a separate corporate tax return each year which means your total annual corporate accounting and tax costs are likely to start at minimum of $2,000 per year.  If your annual tax savings from incorporating is less than $2,000 each year, then it’s probably not worth it.
  • Your business is expected to have losses for the first (or next) couple of years.  Business losses can be used personally to reduce your tax rate against other income, to a certain extent, but not when your business is incorporated. A corporation is a separate entity for tax purposes, so any losses incurred by your corporation can only be used by the corporation. If you’re expecting losses for a little while, then it is best to wait and incorporate later.

 

Another key factor to consider when thinking of incorporating your business is liability protection. This shouldn’t be overlooked, but it is best to talk to your lawyer about this aspect.

And finally, although you can technically incorporate a business yourself rather than hiring a lawyer to do it, I strongly recommend that you don’t. Most business owners aren’t equipped to set up proper share structures, and this can sometimes cause expensive tax headaches down the road when you want to pay out dividends or reorganize your company. It is usually more expensive to fix the share structure later, so it’s best to get it right from the start.