Before incorporating, a business owner should think about tax implications, a corporation’s perpetual existence, and protection from liability.
A common question among small business owners is whether to incorporate a company to carry on their business. However, this simple query often leads to a much more in-depth decision-making process than many business owners expect.
A company is a separate legal entity incorporated for the purpose of carrying on some form of commercial activity. It is important to understand that as a separate legal entity, a company is considered separate from its owners (the shareholders). It can therefore own property and enter into contracts in its own right. Significant implications can arise because of this separate legal entity status that a business owner should carefully consider before incorporating.
1. Tax Implications
First, a company must file and pay taxes as a separate taxpayer from its shareholders. Corporate tax rates vary from individual tax rates. In the case of small, Canadian-owned companies, the different corporate tax rates are often (though not always) quite favorable. Small, Canadian-owned businesses may also be eligible for the lifetime capital gains exemption on the eventual sale of the business. As a result, it is crucial that business owners get accounting advice early on. The tax implications of incorporation are often the primary determining factor when deciding whether to incorporate.
It is also important to keep in mind that the separate taxation of a company comes hand in hand with additional administrative work and professional fees in keeping up with these necessary corporate tax filings.
The business owner must also think about how they are going to move profits earned by the company out to them personally. A business owner cannot treat the company’s income as their own or use the company to pay their personal expenses. For business owners who are used to operating as a proprietorship, keeping company and personal profits separate can take some serious getting used to. The company may choose to pay the business owners an employment or management wage, or the shareholders of the company a dividend. Again, this means more administrative work for the business owner, but it gives them more control of the amount of personal income they receive in any given tax year.
2. Perpetual Existence
The second implication of a company’s separate legal entity status is that a company’s existence is not tied to the lifetime of its shareholders. This means the company can continue in perpetuity (forever). As a result, incorporation can be a useful estate planning tool, particularly for long-standing family-owned businesses. If the company owns commercial real estate, it can save in Property Transfer Tax when passing the real estate down to the next generation.
Business owners must take steps to keep their company in existence. Most corporate registries require a company to file an annual report to remain in good standing, which involves some administrative work and some modest annual fees. If the corporate representatives fail to keep up with these required annual corporate filings, the corporate registry may dissolve the company. The involuntarily dissolution of a company by the corporate registry can create a serious problem if the company owns property. And it can be costly to undo. Therefore, it is essential that a company’s owners stay up to date on their corporate filings.
3. Protection from Liability
The third consideration when deciding whether to incorporate relates to liability. Operating a business through a company provides a certain measure of protection to the individual business owners and their personal assets. For example, if a company enters into a contract with a customer that the company is unable to fulfil, the customer will have the right to sue the company, not the individual shareholders. If the court makes an order awarding damages against the company, the customer may seize the company assets to satisfy the court order. The customer would not, however, be able to access the individual shareholders’ personal assets to satisfy the judgment. The result is a measure of protection to the shareholders’ personal assets, so long as the contract was entered into in the company name, and it was made clear to the customer that the company (and not the individual shareholder) is the party to the contract.
On the other hand, business owners should be aware that the separation of company and individual for liability purposes is not absolute. If the company needs third-party financing, most financial institutions require a personal guarantee of the loan from the individual owners, placing the owners on the hook if the company defaults on the loan. Additionally, there is legislation in most provinces that makes corporate directors personally liable for unpaid corporate income tax, GST, payroll remittances such as CPP and EI, up to six months worth of unpaid employee wages, and some environmental and safety penalties.
Given the many factors to consider when deciding whether to incorporate, it is best to consult with your professional advisors about the business structure that is right for your business.
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The information in this article was correct at time of publishing. The law may have changed since then. The views expressed in this article are those of the author and do not necessarily reflect the views of LawNow or the Centre for Public Legal Education Alberta.
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