You’ve finally found a great name for your business, your business plan has been carefully written, and you’re ready to take off! But when reading about building your business, you come across a word that comes up all the time: incorporation.
However, many businesses can actually incorporate and enjoy the various benefits that consolidation offers, including significant tax benefits. In fact, for some businesses, the tax benefits of incorporation are so compelling that tens of thousands of people become corporations each year.
Tax preparation season is a good time to review your unincorporated business and determine if you should consider changing its status. If you don’t need all of your business income for your personal needs, it might be a good idea to incorporate it. This can represent a lot of things to take into account.
Profits are taxed at your personal income tax rate, which varies depending on your taxable income and the province where you live. Any losses can be used to reduce your taxable income (which will likely reduce your tax liability and possibly put you in a lower tax bracket).
Incorporation is relatively simple, you just need to file an application with your state. This application requests information about your business, including your company name, your personal information, the purpose of your business, and whether you offer stock options. By consolidating your business, your business can continue without an expiration date, which means that even if you die, your business will survive.
I’ll give you the best reasons to incorporate your new business based on tax benefits and give you the information you need to incorporate your business. And don’t worry, I know this can be complicated and we’ve made it easy to understand so you can make the best choice for your business.
Here’s a list of some tax advantages you receive from incorporating your business.
▶ Protect Personal Property
If you are sued as an incorporated business, you are not sued personally, but only your business is liable. Since your business incorporation classifies it as a separate entity, your business assets are at risk, not your home, vehicle, or personal assets.
It’s always a good idea to separate your business from your personal assets. This includes bank accounts, property, etc. As an incorporated business, you can protect your personal assets. It is essential to protect this asset in the unfortunate event that something goes wrong with your business.
▶ Divide the Income
You can make your spouse a shareholder and then wait until you are 65 to pay them dividends. Additionally, if your spouse has worked in the business for an average of 20 hours or more per week in the current year, or if they have done so for the previous 5 years, there is no limit on the amount of dividends you may receive.
For seasonal businesses, the 20-hour-per-week rule only applies during the time the business operates during the year. This can help you split business withholding income with your spouse and potentially put you in a lower tax bracket, so you end up paying less tax. Your spouse will then file taxes under their individual income tax bracket, which if lower than yours, can result in significant tax savings.
▶ The Corporate Tax Rate is Lower Than the Personal Income Tax Rate
Established small businesses can pay very low-income taxes. The small business deduction reduces a business’ federal corporate tax rate by 9% (up to $500,000 in business income), while provincial corporate taxes range from 0% to 3.2%, depending on your province. As a result, the combined tax rate would be between 9 and 12.2% for eligible controlled private corporations. Compare that to your personal income tax rate, which could be 50% or more, depending on where you live and your taxable income.
▶ Benefit Deductions
Incorporated businesses can also deduct the benefits they pay to their employees’ pay stubs. As an unincorporated business with outside help, you cannot deduct these benefits. Another deductible includes the insurance you provide to employees.
Once your business is established, you will be more likely to be taken seriously as a business owner. You become more trustworthy in the community and in the tax world. When this is the case, you are more likely to make money from people who trust you and your business. You are also less likely to be selected for an audit if you are incorporated.
▶ Tax Loss Allocation
As a business, you will likely incur losses, especially in the beginning – most businesses do. Unlike filing income taxes as an individual, a business can spread its tax losses over time.
As an individual, you are obligated to accept the loss immediately, but as an incorporated business owner, you can defer paying taxes. Specifically, if as an independent contractor you have a high marginal tax rate and you personally don’t need the money, you can leave some money in your business and get it back after the tax rate is reduced, personal taxes will be stable.
▶ Tax Savings When You Sell Your Business
There is a lifetime capital gains exemption for incorporated businesses when you sell shares of a qualifying small business. There are a number of conditions that must be met to qualify for the tax exemption, but the tax savings available are substantial. For 2022, the exemption is $913,630.
This could mean that you will have to pay significantly less tax, if any, on profits from the sale. Let’s say you sold your company’s stock in 2022 for a profit of $1 million. You will only pay tax on the difference between the profit and the tax exemption, so: $1 million – $913,630 = $86,370 As a result, only half of this amount, or $43,185, will be considered taxable income.
This option is not available to unincorporated businesses because they cannot issue shares. This can be a huge benefit of consolidation and is often the main reason why entrepreneurs want to consolidate their businesses.
Another advantage is that you can use the lifetime capital gains waiver as many times as you want until you reach the limit.