When to Incorporate

There are two reasons to incorporate. To limit your legal liability, and to defer taxes.

Limiting Legal Liability

When I speak about limiting legal liability, I do so in the most general of terms. If you are considering incorporation specifically to limit your legal liability, please do seek legal advice from a lawyer.

However, in general the concept of limited liability is very much tied to the the idea that a corporation is a separate legal entity. By separate legal entity, I mean that in the eyes of the law, a corporation is a person. As an example, you John Smith, own a corporation called Plumbing Corp. Though John Smith operates Plumbing Corp., Plumbing Corp. is a separate legal entity from John Smith.

When we speak of limited legal liability, we are saying that John Smith's legal liability is limited to the assets he has invested into Plumbing Corp. If Plumbing Corp is sued, any assets held by plumbing corp (bank accounts, equipment, trucks, etc.) are at risk of being lost. But all assets held by John Smith (his house, his bank accounts, his cars, etc) would not be at risk. If John Smith was just a sole-proprietor, and didn't operate under a corporation, both his business assets and his personal assets would be at risk if he was to be sued by one of his clients.

Deferring Taxes

The second reason one may choose to incorporate is the ability to defer taxes. Again, this benefit of corporations is tied to the concept of a separate legal entity. As an individual, you are subject to your own tax brackets. In Ontario, you will pay roughly 20% on the first $44,000, then 29.7% on the next $44,000, and so on. The higher your income, the higher your tax bracket.

As a corporation, your tax rate would be a flat 12.5% on the first $500,000 of active business income (income derived from operations other than renting or earning passive investment income). As long as the after tax dollars remain in the business bank account, you will pay no additional tax.

Here is an example of the tax savings:

Let's say there are two businesses that earn $100,000. One is organized as a sole proprietorship, the other one is set up as a corporation. In both cases, the owners only needs to take $50,000 from the business.

The sole proprietorship would have earnings that are subject to the tax brackets of its owner. For the tax year 2019, and assuming only the basic personal tax credit, the sole-proprietorship would have to pay $24,213 in taxes on the entire $100,000.

The corporation, being a separate legal entity with its own tax rates would be taxed on the $50,000 that remained in the corporation. That would be $6,250. The owner of the corporation would be taxed on the other $50,000, and charged $8,060. Total corporate and personal taxes would be $14,310.

If you compare the two scenarios, incorporating would save you $9,903. That's an extra $9,903 that you can use to invest in your business, grow your revenues, hire new staff, etc. As a sole proprietorship, that $9,903 would have been sent to the government.

So When to Incorporate?

There are costs associated with establishing and maintaining a corporation. It will cost you at least $1,200 to incorporate. Preparing corporate taxes will also cost your between $800 and $2,500 each year. You'll also have to file an annual return with corporations Canada (if you incorporate federally), that will cost you $20 each year.

The answer to when to incorporate is when your tax savings will exceed the annual costs of maintaining your corporation.

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