Earning side income or owning a small business can be a very rewarding experience, both emotionally and financially. The obvious perks of such a venture are unlimited earning potential and a whole lot more freedom and choice.
In Canada a business can operate as a sole proprietorship or a corporation. Often most small businesses operate initially as sole proprietorships and later incorporate for various reasons discussed below.
Editor's Note: The same principles discussed in relation to sole proprietorships apply to limited partnerships.
Legal Structure – Getting The Most Out of Your Small Business
A sole proprietorship occurs when an owner operates a business with no other form of business organization. This type of structure is simple and can easily be created with a few government forms. In most provinces there is a small registration fee – in Ontario it’s $60 to register your business and this is valid for 5 years.
A corporation is a separate legal entity that is registered as such under Canadian law. The owner(s) of the corporation are known as shareholders and do not directly own assets of the corporation nor are they responsible for the debts of the corporation.
If there two or more individuals that own the business, a joint partnership can be set up, which operates similarly to a sole proprietorships. Recently in Canada limited liability partnerships which allow for some liability mitigation but for the purpose of this article we will discuss sole proprietorships and corporations.
Professional fees for a sole proprietorship are fairly minimal. Depending on the size of the business and the number of transactions the owner may be able to pay very little (if anything) in fees to accountants or lawyers. Sole proprietorships typically have the following government reporting requirements:
- Initial business registration
- Annual personal tax returns (T1)
- Payroll remittances and filings (if additional employees exist besides the owner)
- Sales tax (if registered for GST/HST)
A corporation will usually be subject to higher professional fees as the average shareholder likely will require support for the additional accounting and legal requirements. The initially start-up for a corporation may require a lawyer to obtain articles of incorporation, setting a corporate share structure and additional consultations. It is possible to incorporate a business online federally via the Canada’s Corporations website, which is approximately $250. The fee to incorporate in most provinces ranges from $300-$400, depending on the province. Incorporating federally will allow for greater name protection when operating nationally, however, it requires additional filings each year as well as individual provincial registrations. These costs are baseline and do not include any legal consultation which will add at a minimum a couple hundred dollars to thousands extra. Despite the potential high costs I highly recommended a competent lawyer be consulted when setting up a corporation given that it could save large headaches down the road.
Aside from the legal startup costs a corporation will probably incur higher accounting fees for additional government regulations compliancy, bookkeeping and tax planning. Corporations may be subject, but not limited to the following reporting requirements:
- Setting up articles of incorporation
- Annual information return – this is a brief return that details information about shareholders and general information about the corporation
- Maintaining corporate records, which are separate and distinct from personal records (must be held for 6 years per CRA regulations)
- Filing an annual corporate income tax return which include detailed financial statements
- Payroll remittances and filings (if the corporation has employees)
- Sales tax – if sales of the corporation exceed $30k you must register for GST/HST and track sales tax spent and collected
The nature of the above reporting requirements becomes more complex with the operational size of the corporation. (Tip: Regardless of your corporate structure to minimize accounting fees keep on-going organized financial records. Avoid paying your accountant $100/hour+ to sort through your shoe box of receipts)
A corporation requires a T2 annual tax return be filed in Canada with the CRA. This filing requires a set of financial statements along with other information about the corporation. It is a good idea to have an accountant prepare this filing to ensure accuracy and completeness of the information. Depending on how well your records are organized and the complexity of the financial transactions this will cost at anywhere from $1,000 plus per year.
Often I see small business owners of both sole proprietorships and corporations attempting to skimp out on paying professional fees. Having run my own small accounting business myself, and having provided tax planning services in an accounting firm, I understand the value of these services is often difficult to quantify or justify, especially considering the cost of professional fees. However, I’ve also seen situations where personal and corporate bank accounts have been frozen by the CRA for non-compliancy, or an unexpected tax bill cripples cash flow because these issues were neglected. There can be tax minimizing opportunities lost (such as tax deferral, income splitting and other deductions) by business owners when they fail to engage a competent accountant. Paying a competent professional can ensure a business handles these issues before they become massive problems.
A sole proprietorship operates under the owner and all income and expenses are claimed on his/her personal T1 tax return on an annual basis under a T2125. The effective tax rates for 2014 in Canada are as follows (I’ve used Ontario provincial rates here for the purpose of this discussion):
$8,044 in tax on the first $40,120 earned (20% tax rate)
$9,242 in tax on the next $30,531 earned (30% tax rate)
$6,063 in tax on the next $17,256 earned (35% tax rate)
After you’ve earned over $90k you’re looking at approximately 40%-50% tax on each additional dollar earned. Our tax system works like this to provide lower tax rates to low income earners and higher rates to higher income earners (in theory).
At the end of each year you add up all the business revenue you earned in the year and subtract all the related expenses (note: you can deduct non-direct expenses such as office and vehicle expenses of a business on a pro-rated basis). The net income (earnings less expenses) is then used to determine the amount of tax you owe. For example, if you earned $50,000 and had $30,000 in expenses for a net income of $20,000 you would have a tax bill of approximately $4,000 [($50,000 – $30,000) x 20% tax rate].
The corporate small business tax rate in Ontario is 15% on the first $500,000 of income. Sweet sassy molasy, that’s way lower than the personal tax rates above. Why doesn’t everyone just incorporate? I know, right? Well, hold on there that rate is for income earned in the corporation and it must stay there until paid out to the owner via salary or dividends. This is where tax planning comes into play and can drastically affect your take home pay if you’re earning some decent money. Here’s an example of a business earning $100,000 in income under the sole proprietorship VS corporation.
Now recall that for a corporation we have to pay a salary out to the owner in order for him or her to access the profits. If the owner wanted $70,000 in salary and wanted to leave $30,000 in the business for future investment it would look like this:
|Net Income||$100,000||$30,000 (reduced by $70k salary)|
|Business Taxes Payable||$26,600||$4,650|
|Employment Taxes Payable||$15,000|
|Total Taxes Payable||$26,600||$19,650|
By incorporating and paying a $70k salary the business owner would save close to $7k in taxes. If the business owner would live off a salary less than the net income of the corporation we can see considerable tax deferral and capital appreciation by leaving the funds in the corporation and investing. The Canadian corporate tax rate has decreased substantially over the last few decades to encourage business spending.
Typically expenses written off by corporations can similarly be written off by sole proprietorships, however, a corporation allows for additional income splitting in certain situations which may lower overall taxation. For example, suppose a spouse is the shareholder of a corporation that manages the overall operations of the business. If the other spouse helps out the business with administration and other tasks a reasonable salary can be paid which can be written off by the business and taxed at a low personal rate. (WARNING: the salary paid to the spouse should be no different than if an outside individual was carrying out these tasks. If the CRA deems the salary unreasonable they may tax the administrative spouse on the income AND not allow the corporation to write-off the salary = DOUBLE TAXATION)
Taxes and the entire process around them can be confusing, but they are inevitable. By being proactive and talking with a professional accountant you can ensure you’re not taking any more of a financial tax hit than necessary.
Corporate Compensation: Dividend VS Salary
Paying an owner of a corporation out can occur via dividend or salary/bonus. Over the years the CRA has adjusted tax rates on these compensation methods in an attempt to make a taxes payable equal under both methods (known as integration). Prior to 2014 in general there was a tax benefit to compensation via dividends; however, in 2014 the federal government essentially leveled the playing field between salaried compensation and dividends.
Dividends are taxed differently than regular salary in order to promote integration. A non-eligible dividend (which are amounts paid out from the corporation’s net income that were taxed using the 15% corporate small business rate) is grossed up by 18% to calculate taxes owing and then reduced by a tax credit. Sound confusing? It is, but here’s a quick example of how a dividend of $100,000 would be taxed to the recipient in 2014.
|Dividend Tax Credit||$5,310|
|Net Taxes Payable||$28,944|
The purpose of this complex tax calculation is to support integration which will result in equal tax regardless of whether the shareholder pays themselves via salary or dividends.
Each owner has a unique situation in which other factors should be discussed with an accountant in order to determine the optimal compensation method. (i.e. payroll taxes, generating RSP room and withholding taxes)
Protect Your Ass-ets
We live in a litigation crazed world nowadays. Every small business is at risk of lawsuits or other claims that can arise from business failure, error or negligence. These types of risks can never be fully avoided and are another cost of doing business. However, by acknowledging these risks and taking preemptive action you can substantially mitigate the dangers and potential costs of such claims.
Under a sole proprietorship the owner is personally responsible for all debts and liabilities and legal costs of the business. These debts may include credit cards, business loans or liabilities arising out of lawsuits. If the small business operating as a sole proprietorship is unable to fulfill these debts a creditor almost certain to seek restitution through the forced sale of personal assets (house, car, investments) of the owner in court.
A corporation allows for an owner/shareholder to separate him or herself from the legal responsibilities of the business. If the corporation is unable to pay debts or liabilities the creditor or plaintiff may only seek assets owned by the corporation and not the shareholder. There are certain situations in which a shareholder may be personally liability, such as providing personal guarantees for corporate debts, remitting sales tax and payroll remittances, so talking with a knowledgeable lawyer is always a good idea.
Taxes and the entire process around them can be confusing, but they are inevitable. By being proactive you can ensure you’re not taking any more of a financial tax hit than necessary.
Incorporation: Is it right for you?
There are a lot of other considerations when thinking about incorporating a business. While the administrative and compliance responsibilities and costs are much greater under a corporate structure the benefits include liability mitigation of the owner, tax savings and estate planning. It probably doesn’t make sense for a small business with minimal operating risk and net income under $50k to incorporate as a low tax rate is already enjoyed. As a business grows so too do the tax liabilities and operational risk, which may indicate it’s time to prep those articles of incorporation. When a business reaches net income above $50k it may be a good time to discuss if it’s time for incorporation. Each business owner should consult with a lawyer and accountant to determine if the increased costs are offset by the benefits.
About the Author
Jon Woychyshyn, CPA, CA, is a Canadian professional accountant and personal finance and lifestyle blogger with experience in public accounting and corporate finance industries. He aims to provide his small business clients with personable financial advice that help them reach their business and individual goals. Feel free to contact Jon via his blog at www.thewealthbrickroad.com