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Sole Proprietor or Incorporation?

When starting a business in Canada, one of the most important decisions you must make is whether to incorporate or operate as a sole proprietorship. This can have financial, tax and liability implications.

It partly depends on your goals. If you are primarily serving as a consultant or freelancer and do not expect to add employees to generate millions in revenues, you can consider operating as a sole proprietorship.

On the other hand, if you have developed an exciting new product or ground-breaking software, you may choose to incorporate so that you can eventually sell shares to prospecting buyers.

Fortunately, you can change your mind as your business grows by incorporating a sole proprietorship. You can convert a sole proprietorship into a corporation by paying a government fee and getting a lawyer (or DIY, just ask us!)to help you set it up. You may even be able to use the same name (provided it’s available) and add the word Inc. or Ltd. at the end.

Similarly, if you own a corporation and decide to semi-retire or scale back your business, you can close the corporation and go with a sole proprietorship.

Legal structure

The primary difference between a sole proprietorship and a corporation is the legal structure. A sole proprietorship is just you personally. So, if your business is sued, you are liable. A corporation is a separate legal entity with limited liability.

Tax Strategy

There are different tax strategies depending on which option you choose and the profitability of your business.

If you have a sole proprietorship, you report any income from the business directly on your personal tax return. During the start-up phase, you may have some business losses and these can help to reduce your income for tax purposes. Therefore, you may end up paying less tax.

Incorporating can have tax benefits. Companies are taxed at a lower rate than personal income, so you may end up paying less tax. In addition, you can choose to keep money in the corporation rather than distribute it to shareholders (such as yourself) as a dividend. This can help to reduce your personal tax owing. Although it doesn't avoid taxes, it defers it - welcoming tax planning strategies that may benefit you years down the road.

Sole proprietorships do not offer this flexibility. Any income that you earn from your business must be reported directly on your personal income tax return – and you will have to pay tax on it.

Professional Fees

One of the biggest differences between the two business structures is the need for professional advice from lawyers or accountants. If you decide to start a corporation, you will need legal advice in order to set it up. On the other hand, it’s simple to register a sole proprietorship.

Similarly, the need for accounting services is a difference between a sole proprietorship and a corporation. With a sole proprietorship, you simply report your income on your personal tax return – so you may not need an accountant at all. Refer to our article on personal taxes!

For a corporation, you may need assistance from an accountant to file the required corporate tax return.

Dividend vs. Salary

If you have a sole proprietorship, your income must be taken as a salary. There are more tax advantageous options with corporations. You can pay yourself a salary or take the entire amount as a dividend – or opt for a combination of both. Dividends receive favourable tax treatment so you may want to look into which option works best for you.

With corporations, family members (such as your spouse) can be shareholders and therefore eligible to receive dividends. Your spouse can also be an employee provided that he/she legitimately works for the company. These strategies allow you to split income between you and your spouse, which may reduce your overall tax liability.

Risks of a Sole Proprietorship

With this type of business, you are personally liable for any debts or judgments resulting from a lawsuit. This means that your assets, such as personal savings and your house, can be seized to meet these financial obligations.

It can be difficult to raise capital if you decide you need funds to expand your business. That’s because you cannot offer investors shares in your business, like you would if it were a corporation. If your business carries a lot of risk, you may prefer to set it up as a corporation.

When you decide to retire, it can be difficult to sell a sole proprietorship. On the other hand, a corporation lives on even if you die; it can be easily sold if you or your heirs can find a willing buyer.

Risks of a Corporation

There are not a lot of risks with incorporating, but there are disadvantages. These include the requirement to file a separate tax return and keep corporate records. Normally, you will need an accountant (this is where we shine!) to help you with your corporate income tax return, which adds an extra layer of cost.

In Conclusion

When you set up your business, you can weigh the pros and cons of a corporation vs. a sole proprietorship. It’s a good idea to consult with your accountant to get advice on which is best for your particular business. We are always happy to discuss this with you, it is after all what we do everyday!

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