As a CPA providing bookkeeping services, I often get this question:
When should I incorporate?
Incorporation has Pros and Cons and we’ll step through them here to help you decide.
Risk is isolated.
If you do business as a corporation, you limit the risk of loss to the amount of your investment. This is especially important when you are running a high-risk business where your customers or your employees may be injured. Examples include construction & trades businesses, gyms, and personal trainers. Accidents happen. Even if it might not be your fault, you may be sued. If you are, and you don’t have enough insurance, you will be personally liable. Prevent this situation at all costs.
A caveat: In Canada, a corporation doesn’t necessarily protect you against gross negligence or fraud. In those situations, your corporate veil can be “pierced”, and you could be personally liable.
Much clearer data.
If you have a bookkeeper that supports you with financial intelligence, having a corporation can really help. A sole proprietor doesn’t have a balance sheet because personal and business assets and liabilities are all mixed together. Therefore, it’s hard to do analysis, such as Current Ratios, Return on Asset, Return on Equity , Debt to Equity Ratio . It’s even hard to do a Cashflow Analysis, and as you know, in small business, Cash is King.
You might be wondering—do I even need this data? When you are small, you probably don’t need deep analysis and ratios. You can tell how your business is doing by looking at your bank account. As your business grows, it’s important to have keep track ratios as your Key Performance Indicators (KPI’s) and do Cashflow Analysis to help you make decisions to take your business to the next level.
Additional credibility and name protection.
When you have Ltd. or Inc. behind your business name, people tend to trust you more. People believe you are an established business and not operating alone. Also, when you incorporate, you must do a “Name Search“, The name search process helps you find a unique name for your business. A distinctive name helps you stand out and protects your brand.
Existence despite the owner.
A corporation is its own entity. If something happens to a business owner, the corporation would still exist. A separate entity is especially important if you are older, and want to the business to survive longer than you.
Flexible financing and/or tax planning opportunities.
The shares of the company can be sold to investors to raise money. This may be the only way if you are a high-risk business and bank financing isn’t an option. This is true of many startups. If you are a highly profitable business, the shares of a corporation can be held through a Holding Company, or a Family Trust to take advantage of Income Splitting, a legitimate method of tax avoidance.
If there are so many benefits of incorporation, why don’t more people do it?
Incorporation is more expensive.
Generally, filing a corporate tax return is more expensive than an individual tax return. A corporate return costs $2,000/year or more. A personal return, with business income, may cost you up to $1,000. If your bookkeeper did a good job, your taxes will take less time, and you may see savings at year-end. Beyond the costs of financials, you also have more work. You must file legal documents and keep your Minute Book active and accurate. On the banking side, you will need to open a business bank account and a business credit card, which means more bank charges. Bank charges add up.
It’s more of a hassle.
It’s much easier to be a sole proprietor. The business is you, and you are the business. The bookkeeping is easier, and overall, you don’t have to worry about a corporate entity and the associated paperwork.
Losses cannot be deducted personally.
If you have a new business and you are still losing money, it might be a good idea to not incorporate. When losses happen in a corporation, then only the corporation can claim these losses. A new business typically loses money in the first 2-5 years, so it might be a while before you can use these losses to reduce your tax burden. On the other hand, if you are a sole proprietor, business losses can be claimed against your personal income, and it can be used right away.
Now that you know about the pros and cons from a bookkeeping point of view, when should you incorporate?
There are no hard and fast rules, but generally, if the Pros start to outweigh the cons, then you should do it. Sometimes, the benefits are there from day 1. For example, if you run a high-risk business, and want to protect yourself, it might be wise to incorporate to get that peace of mind. Of course, you can also purchase enough insurance to achieve the same effect.
Generally, if your business’s net income is near $60,000, you might be fine either way. However, if your income is greater than $60,000, then it might be better to incorporate to take advantage of tax planning opportunities.
Now that you’re armed with the answers to “When Should I Incorporate?”, are you ready to make the right call?
Click here for our free 30-minute consultation to go through whether you should incorporate.