Jumping from Sole Proprietorship/Partnership to Corporation in Canada

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

Jumping from Sole Proprietorship to Corporation in CanadaProfessional 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.

Tax Strategy

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.

Sole ProprietorshipCorporation
Net Income$100,000$100,000
Taxes Payable$26,600$15,500

 

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:

Sole ProprietorshipCorporation
Net Income$100,000$30,000 (reduced by $70k salary)
Business Taxes Payable$26,600$4,650
Employment Income$70,000
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$100,000
Gross-Up 18%$18,000
Taxable Dividend$118,000
Tax Payable$34,254
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

26 Comments

  1. Seann on May 24, 2015 at 5:00 pm

    Great article! I’ve been searching all over for someone to break through all the confusing tax talk and present the pros/cons in some hard numbers. I’ve been struggling to decide if incorperation is right for me. In the last year my sole-proprietorship income has grown quite a bit. Basically it comes down to this. Say I make 100k gross this year and I support my spouse but I plan to buy a house and aggressively pay down the mortgage with every penny I earn. Does it make sense to incorperate? I currently can handle my own taxes so my accounting fees are 0 which won’t be the case once incorperated so I figure it only makes sense if I can save a substantial amount of $$$. But if I want to have access to all of my income there’s no benefit from deferring to another tax year and I think the savings in income splitting wouldn’t be all that different from what I would then have to pay in legal & accounting fees. I plan to talk to an accountant in detail about all this but was wondering what your take would be on it? Any insight at all would be greatly appreciated. Thanks so much!



  2. Kyle on May 26, 2015 at 8:59 pm

    Hey Seann, glad you found the article to be helpful. It’s definitely best to consult an accountant in these cases. I think from the little you gave me here that it would likely make sense for you to incorporate because of the huge advantage of income splitting in your case. For example, right now your marginal tax rate is quite high, but if you took that same 100K in cash flow, and paid yourself a 60K salary, with your wife then taking 40K in dividends (dividend income doesn’t have to be split evenly amongst owners) the average rate of tax paid would be substantially lower. Also, those accounting fees will be deductible as a business expense – so that’s a nice perk! I think you would save considerably more than the incorporation and accounting fees, especially after the first year, but best to talk to an accountant about that.



  3. ansonn on September 9, 2015 at 11:48 pm

    Nice article, informative and clear. I’m also looking into incorporating a new business. One thing I’m concerning is that when you compared between salary and dividend, is there a missing portion on employer and employee portion of CPP contribution and EI premiums when salary is paid out to yourself?

    Also, I had the impression that the amount of dividend paid out needs to be in proportion to the share portion among shareholders. Is this correct or not? For example, if my spouse and I each owns 50% of the shares, then dividends need to be shared evenly among the two of us?

    One more question, after incorporation, do I have to do scheduled payroll to myself or can I do a lump-sum once a while or decide on the salary amount at the end of the fiscal year? If this sounds like the idea of a bonus, in other words, can my corporation pay $0 salary and a one-shot bonus to myself?



  4. Kyle on September 11, 2015 at 8:24 pm

    Hi Ansonn,

    Glad you appreciated the article. There is a missing portion – we didn’t go into that just for simplicty’s sake. You need to factor that in as well.

    In terms of the dividend, you have the wrong impression. You can pay out 100% of the dividends to one shareholder (your wife) if you want to.

    You can do a lump sum as far as I’m aware.



  5. izn on October 11, 2015 at 4:49 pm

    Hi Kyle,

    Very good article, exactly what I was looking for as I’m planning to incorporate business.
    In paragraph where you compare tax for Sole Proprietorship and corporation business taxes your wrote that Payable Tax for SP is $26,600 (on $100,000 earnings). That means tax is only 26% but it should be more, right?

    Could you please explain Canadian-controlled private corporation. Is this an option or all registered companies are CCPC by default (if founders are citizens of Canada)?

    Best,

    Izn.



  6. Kyle on October 13, 2015 at 1:30 pm

    All companies that are registered in Canada are Canadian controlled to the best of my knowledge Izn, but I’m a little out of my depth there. The comparison you’re looking only takes into consideration the provincial tax rate I believe.



  7. Jason Gomberg on January 4, 2016 at 12:18 pm

    Thanks for the great article. Just one question in regards to income splitting. I have started thinking of incorporating with my wife, with 51% class a shares for me, and 49% class b shares for wife. Would I still be able to allocate 100% of dividends to her under this arrangement? Thanks, Jason



  8. Kyle on January 5, 2016 at 3:16 pm

    Yes, you absolutely could Jason. Double check with an accountant on this, but I’m 99.9% certain on this.



  9. luciana on January 25, 2016 at 8:13 pm

    Thank you so much for this explanation! i am wondering if you have a list of deductions. Are gym membership deductible for me an my partner?



  10. Kyle on January 25, 2016 at 10:09 pm

    I’ve never heard of gym memberships – but I guess it’s conceivable if you could somehow tie it into your ability to do your job.



  11. Me on February 15, 2016 at 8:33 am

    Awesome article!



  12. Bayley Rute on May 1, 2016 at 8:43 pm

    Good article. I will be consulting for a US company. I will be paid in US dollars. Should I incorporate if I take most of the cash out for myself? Also should I be converting to Canadian dollars immediately?

    Thanks,



  13. Kyle on May 4, 2016 at 9:07 am

    I don’t know if that would really come into consideration Bayley. I’d ask my accountant on that one.



  14. Christopher.si@gmail.com on May 5, 2016 at 12:19 pm

    Thank you so much! It’s succinct and to the point. Thanks again!



  15. Roland on December 31, 2016 at 5:46 am

    Thank for such insight. However what would u say a fair fee is for the professional fees you spoke of. I recently did the switch and am suspicious my accountant took advantage . Had me pay 1500. From your experience what would u say is fair.



  16. Kyle on January 3, 2017 at 10:49 am

    From everything I know, that is pretty standard Roland.



  17. Ansh on January 8, 2017 at 8:16 pm

    Great article,Kyle! I would really appreciate if you can provide your insights on my query.
    Query: I am a Canadian Permanent Resident living in British Columbia. I am planning to start my own online business by January 30,2017. My online business model is selling physical products by importing them from China and selling it to customers on Amazon’s USA website utilizing Amazon’s famous FBA program.The thing I am most confused about is whether I should Incorporate right away in British Columbia OR Start as a sole proprietorship initially? From the articles I have read online on eCommerce blogs, most people suggest to start off as a sole proprietorship and Incorporate in British Columbia only after I start making at least $50,000 a year. But per the unique product idea I am having, I am confident that I will start making at least $10,000 in profits every month from July 2017 itself but I might be wrong. So is it recommended that I incorporate right away? If I start as a sole proprietorship for now and decide to incorporate in BC after 6 months once I start making substantial income from my Amazon business, will it be too much hassle to convert my sole proprietorship to Corporation? I am bit concerned about going this route because if I decide to convert from sole proprietorship to Corporation after 6 months then I would have to apply for EIN again from IRS in USA and also I won;t be able to take out profits from the Corporation to pay for my personal expenses in BC because I read online that profits from Corporation should STAY in the corporation otherwise I will have to pay high taxes if I take out the profits every month from the Corporation for Apartment rent payment and other personal expenses so not sure what should I do. I have talked to 2 tax professionals so far here in BC but both said they can’t advise on this topic as this whole eCommerce tax thing is new to them. I am very hopeful I will get insights from you on this topic which is now becoming common amongst Canadian sellers selling on Amazon USA website. Thanks ahead of time!



  18. Kyle on January 18, 2017 at 3:13 pm

    Hello Ansh,

    First of all, if your store really is that profitable, then it is I that needs to be asking you for advice!!!

    I would tend to agree with the $50-$70,000 rule of thumb for going to a corporation. If I was sure I was going to hit that mark in six months I wouldn’t hesitate to start with a corp from day one. The real question is do you have the start up capital to deal with those bookkeeping costs up front? You could certainly take profits from your corporation through paying yourself a salary or through dividends – just FYI. To be honest, I will have to parrot the tax professionals you talked to when it comes to anything specific to eCommerce. You might have better luck recruiting am American tax professional to help guide you through the process.

    Good luck and let me know how it goes!



  19. Sean on January 18, 2017 at 3:23 pm

    Hi Kyle,

    Are you familiar with the rules regarding capital gains exemption on disposition of the corporation upon sale ? Meaning if I have a SP and convert to a CCPC the assets can be transferred at FMV and not trigger disposition. CRA states a individual owner of a CCPC can only use the capital gains exemption after a min 2yrs of operation as a CCPC. If the SP has been in existence for some time already are their exceptions to this rule? Obviously, I’d like to take advantage of the 850K CGE but looking for a way around the 2yr rule. Looking to sell 1/2 the business ..Thanks in advance!



  20. Kyle on January 19, 2017 at 11:52 am

    There’s no way around it that I’ve ever come across Sean, but truth be told I’ve never researched it too hard having never sold a business worth a substantial amount (hopefully one day!).



  21. Rob on March 31, 2017 at 3:34 pm

    Great article Kyle.

    One additional question though: if I currently have a sole proprietorship that has been in operation for several years and then I create a corporation, what steps do I have to take tax-wise for the sole-proprietorship in order to close it out. My thoughts right now are that I simply disclose that in my T1 that it is the final year and submit a T2 for the corporation for the small portion of the year that it overlapped. This is a software games company so the assets are purely intellectual. Also, the trade name and corporation name are identical except for the Inc. if that has any implications.



  22. Kyle on April 1, 2017 at 11:31 am

    To the best of my knowledge, that should be fine Rob. Any certified accountant should be able to tell you for sure one way or the other.



  23. Tim on November 23, 2017 at 9:07 am

    Hi Kyle,
    I am currently in a position where, I am retired, 59 years old, with a current payable pension of $72K. I have been asked by my former employer to come back as a contractor. The scope of work for 2018 could be $57k min up to $88k max. at an incorporated rate. The SP rate would be $52k to $79K. Due to my personal non-business income, I am not sure at which route to go. I realize Inc is much more costly to maintain, but the depreciation of my pension thru taxation is also a concern.



  24. Kyle on November 24, 2017 at 10:49 am

    Hey Tim – You’re going to have to pay a personal tax rate on salary income taken from your corp (or dividend income after paying the tax rate anyway). You can do the math for your situation, but with passive income now being taxed in corps, I don’t see too many advantages to incorporating in your situation.



  25. Alan Overend on February 19, 2018 at 6:54 pm

    Great article Kyle. It helped to explain some of the basic concepts to me. I was wondering if you could share some comments on my situation. I am a fully employed PEng but will be terminated at the end of June 2018 (the firm wants to get out of my line of business). No golden parachute here unfortunately. I am 66 years old but not financially well off enough to retire. My wife and I own a small incorporated (real estate holding) company (Holdco), which receives about $30G in annual gross rental income. Its taxable income is minimal to non existent most years (prepared by a CGA for which I pay $2 to 2.5G in fees per year). I intend to work on my own after June, but only for say 2 to 3, possibly 4, more years. Expected gross annual working revenues would range from $100 to 150G. My question relates to whether I should work as a SP or work as an owner/employee within the existing Holdco. The latter I suspect would change the status of the Holdco from a passive to an active company and also cost more in accounting fees. I would have to get professional liability insurance in either case. Any comments would be appreciated. Thanks



  26. Kyle on February 21, 2018 at 3:37 pm

    Your instincts confirm my own Alan. I wish I had more to add, but that’s pretty much exactly where my expertise stops as well!



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