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BUSINESS MANAGEMENT
Should My Business be Incorporated?
Given the number of corporations registered in Ontario one would have to assume that this is the generally accepted form of business ownership. When did the owner’s decide that incorporation was the best form of ownership? On what criteria did they base their decision? What are the alternatives? As with most other aspects of business management the answers to these questions are not straightforward. The decision to incorporate is based on individual circumstances and the relative importance of a variety of factors.
Probably the most important feature of a corporation is the separation of the shareholder from the operations of the business. The corporation, being a self-functioning entity, has the ability to conduct its own affairs; to buy, sell, enter into contracts, sue and be sued. This separation has the effect of limiting the shareholder’s liability to the amount that he has invested. Neither the company itself, nor the creditors of the company, have the legal right to extend the shareholder’s liability beyond this investment.
Under a proprietorship or partnership structure the owners of the business and the business itself are inseparable. Creditors seeking to recover monies owed by the business can look to the personal assets of the owners to realize payment.
Typically, in a small business corporation, the shareholder(s) of the company will also be its director(s). Directors, because of their fiduciary duty (duty of trust) to the corporation, have significantly more statutory and common law liabilities than do shareholders. Directors can be held personally liable for such things as unpaid wages, employee deductions withheld, certain capital transactions which cause insolvency and other actions which prove to be negligent. “Piercing the corporate veil” is becoming more and more prevalent under both statutory and common law.
Income tax plays a major role in many decisions regarding incorporation. The tax advantages or consequences deserve careful attention.
Currently, in Ontario, the corporate rate of tax is approximately 19.2% on active business income under $200,000. Personal income tax rates start at 22% and move to 31% after taxable income reaches $31,000. This means that the corporation pays less tax on business income than does an individual operating a business in a proprietorship or a partnership.
There is, therefore, more after tax profit left with which to make principal payments on debt, finance inventory and accounts receivable and purchase fixed assets.
The tax differences between an incorporated business and a proprietorship are essentially negated if the shareholder withdraws the income from the corporation. The tax advantage exists only on profit left in the company. Generally speaking, a business will realize a tax advantage by incorporating if it is making significant principal payments on debt, purchasing major fixed assets, and/or experiencing increases in inventory or accounts receivable.
A corporation is also a convenient vehicle for making tax-deferred transfers of a business to one’s children. There are several methods available to “freeze” the value of a parent’s share of a corporation and pass the future growth potential on to his or her children. These types of estate plans can be used to realize the $500,000 capital gains exemptions, fund retirement and provide an inheritance for children not active in the business.
The corporate form of ownership does have several disadvantages. The corporation must file tax returns both federally and provincially. It must also observe certain legal formalities such as annual shareholders’ and directors’ meetings, election of directors and appointment of offices. A shareholder cannot withdraw money form a company as a proprietor draws money from his business. Monies withdrawn from a company must be in the form of wages, dividends or payments on debt owed to the shareholder. There are various tax consequences that arise when a shareholder becomes indebted to his company.
The decision to incorporate cannot be based on a standard set of criteria. Each circumstance is different. One must weigh the advantages of limited liability and lower tax rates against the additional administrative requirements. A business owner should, however, give careful consideration to incorporation and consult his or her advisors periodically to see if it may be appropriate.
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