When is the best time to incorporate a business?

Welcome to our new Ask the Accountant series, where our clients and readers pose accounting, finance and business management questions to KRP partners Hartley Cohen and George Grignano. Have a question you’d like answered? Email us now and we’ll put your query in the queue.

Q: Thanks to a handful of new clients, the management consulting company that I’ve operated on my own for the past few years has grown quickly—to 10 employees—over the past year. Our revenue has also increased substantially. Until now, I’ve operated as a sole proprietorship. Given this new growth, should I incorporate?

It’s a great question to launch this series, and a fundamental concern of most entrepreneurs at some point in the start-up phase.

There are two main considerations when deciding to incorporate: legal liability and taxation. Let’s start with the former.

The directors and shareholders of incorporated businesses enjoy a certain degree of protection from legal action—but it’s limited. By incorporating, you can theoretically shield your personal assets from your business activities. Meaning if your business is sued, your personal funds or property won’t be exposed. While it may not be a major worry for a consulting firm such as yours, this is particularly important in industries such as food processing or construction, where major errors can cause widespread physical or financial harm to customers or the wider public. If yours is an incorporated food processing company that experiences a major bacterial outbreak, for example, liability is likely to flow to the company and not its directors, assuming those directors are not found to be negligent in their business practices.

It’s the same reason why construction companies employ a multi-corporation strategy. Every construction project will have its own corporation. If there is a catastrophic problem with one project, then the other projects in the builder’s portfolio are protected from creditors (in the case of insolvency) or lawsuits (in the case of an injury or other legal claim relating to claims such as poor building practices). As another example, tech firms use a similar strategy to separate their intellectual property assets from their operating companies.

The exception, generally, is when gross negligence can be proven—this is where director liability insurance can be a useful tool to limit liability—as well as in the case of labour law violations. At that point, incorporation will offer directors minimal protection from legal liability.

There are other exceptions, such as the collection of HST, and payroll deductions.  The Canada Revenue Agency will hold company directors personally liable for collection and remittance of relevant taxes, whether incorporated or not. If you’re borrowing funds from a bank, most start-up entrepreneurs will be asked to personally guarantee a loan, which could potentially expose personal assets such as their principal residence.

The best way to determine when to incorporate is to take an overall approach that examines potential liability, as well as the tax implications. If you’re just starting a business and expect minor liability exposure as well as short-term losses, it can make more sense to operate as an unincorporated entity. In this case, business losses can be applied to reduce personal taxable income and effectively lower personal taxes.

You need to consider that it can cost upwards of $1,500 to incorporate a small business including legal and accounting fees, and potentially much more depending on the size and complexity of the corporation in question.  Also consider ongoing costs to maintain a corporation such as costs for bookkeeping, general administration, professional fees for legal compliance and professional accounting fees which would include at a minimum financial statement preparation and annual corporate tax filings. Depending on the size and complexity of the business, this can add up to several thousand dollars per year.

Having said that, any growth-focused business with significant revenue or assets, employee headcount and potential liability exposure will almost certainly incorporate—in your case, that means now is may be the right time to take the corporate plunge thanks to growth in staff and sales.

Generally speaking, however, if your business is profitable and liability is not an issue, but you’re drawing out all income from the business to live, incorporation offers few advantages.

If, on the other hand, retaining earnings in the business is realistic because net income exceeds your personal lifestyle needs and other financial obligations, then incorporation can offer major tax deferral benefits. Remember, corporate income taxes in Canada are low—just 15 per cent on the first $500,000 in annual corporate income. This compares to about 30 per cent and higher in personal tax on income in excess of $45,000.

Keeping more income in a corporation will provide more after-tax cash which can be used to re-invest in working capital, other operating assets or passive investments such as real estate, preferably through a holding company.

Many organizations use their incorporation as a branding tool, positioning their organizations as a legitimate going concern with ‘Inc.’ after their names. Incorporation also forces entrepreneurs to separate their business and personal finances, which makes it easier to manage accounting and acquire financing from a bank, other lenders or investors.

Further down the road when selling the business, incorporating can make strategic sense due to specific tax benefits when disposing shares of the corporation.

The bottom-line: incorporation becomes essential for virtually all growing businesses, particularly when profitable or facing increasing legal risk exposure. Entrepreneurs operating small start-ups should work with their accountants and lawyers to analyze their personal financial situation to determine the optimal time to incorporate.

In our next column, we’ll examine the benefits and risks for entrepreneurs who choose to pay themselves dividends out of their corporation, in lieu of a salary.

Hartley Cohen and George Grignano, partners,

Kestenberg Rabinowicz Partners LLP

Hartley Cohen

905-946-1300, x. 223