Businesses in Canada1 can take the following legal structures: sole proprietorships, partnerships, corporations or co-operatives. The decision on how to structure your business will depend largely on your current needs and future goals. Many entrepreneurs initially choose to structure their business as a sole proprietorship2 because they are simple and less expensive to run, and all profits go directly to the business owner. There are also several advantages to structuring your business as a corporation3 and deciding to incorporate your sole proprietorship can open up new opportunities.
When is the right time to incorporate your sole proprietorship? What trigger points should encourage you to think about incorporating your sole proprietorship? Here we’ll take a look at three different businesses to help you take the leap from sole proprietorship to corporation.
Business 1: Jay, the Spanish tutor is opening a school
Jay teaches a number of students each week, and is the sole proprietor/exclusive owner of his business – Master Your Spanish. Over a period of time Jay has made a name for himself in the community, his student count has gone up, and he makes a good profit each month.
He feels the time is right to capitalize on his credibility and expand his business. He’d like to open a language school, hire other tutors, and run digital ads to sign-up new students. Jay’s growth plans need investment or a business loan.
Unfortunately, as a sole proprietor Jay may find it hard to qualify for a business loan. Banks require collateral like real estate, equipment, inventory, purchase orders among others as a guarantee against a default. Without these business assets, a sole proprietor’s personal assets will need to be put up as collateral.
Lenders also want to see the business generating a certain minimum annual revenue and may prefer to lend to a business that has been operational for some time. A sole proprietorship may or may not be able to show consistent income and work-orders.
If a business loan is not available to Jay, what are his options as a sole proprietor? He can either dip into his own savings, borrow from family and friends, start a crowdfunding campaign, seek government grants, or apply for a personal loan to use for business. But here’s what Jay has to watch out for:
- As a sole proprietor, you are your business. If your personal credit score is poor, it affects your ability to obtain a personal loan.
- The personal loan has your name on it and not the name of your business meaning you are personally liable to pay back the entire loan.
- The borrowing limit of a personal loan is usually lower compared to a business loan, and if you’re unable to provide collateral, you’re likely to receive a higher interest rate for the personal loan.
If Jay were to incorporate his sole proprietorship, his access to business loans may improve and he might get a better borrowing rate. It could also make it easier for him to attract outside investment in his business. He could also sell an ownership stake in his business to friends/family, angel investors or a venture capital firm in exchange for funding.
Business 2: Sara, the landscaper facing liability risk
Last year, Sara left her full-time job with a major landscaping company to become an independent contractor. She branched out during peak spring to tap into the seasonal demand for lawn-care jobs. At the time, she found she could get up and running the fastest if she structured her business as a sole proprietorship.
Over the past year, Sara’s business has matured, she has regular clients, and her net income is improving too. She relies on word of mouth to find new work, and the quality of her service is critical to her. Everything is going well, until one day an equipment malfunction damaged her client’s flower bed.
She was able to resolve that mishap amicably with the client, but it opened her eyes to the liability she is exposed to as a sole proprietor. Here’s how the Canadian government sees it:
“The owner of a sole proprietorship has sole responsibility for making decisions, receives all the profits, claims all losses, and does not have separate legal status from the business. If you are a sole proprietor, you also assume all the risks of the business. The risks extend even to your personal property and assets.” – Canada Revenue Agency4
As a sole proprietor, Sara has personal liability for her business’ activities. Any bodily injury or destruction to property on the job can get her personally sued for damages, and invite legal claims on her personal assets. An incorporated business on the other hand separates Sara’s personal liability from the liabilities of her business. In Sara’s case, her business carries the potential risk of property damage or an injury because her service is delivered on the customer’s land and utilizes heavy machinery. Her growing landscaping business may find the limited liability of a corporation beneficial.
Business 3: Julie’s IT consultancy is booming
Julie’s part-time gig as an IT consultant has grown into a full time contract this month. The increased hours is great, and it’s a considerable climb in her annual income, however, Julie’s now profitable sole proprietorship will put her in a higher tax bracket.
A sole proprietorship operates under the owner’s name alone. Income generated by a sole proprietorship is taxed at the owner’s personal tax rate. If Julie’s IT consultancy business were incorporated, her business income would be taxed at federal or provincial corporate tax rates, which are generally lower than the individual tax rate**.
As a corporation, Julie would also be eligible for tax deductions on any eligible expenses or big investments that are essential to her IT consultancy. Travel costs and health insurance costs also come under its purview.
The income-splitting benefit of a corporation may reduce Julie’s tax burden further. The owner of the corporation can separate themselves from the company by paying themselves and any staff they hire a salary, which is then taxed as per their individual tax bracket. It’s important to remember that income earned by a corporation can only be taken out as a salary, an expense or a dividend paid to shareholders. By structuring her business as a corporation, Julie can take advantage of the fiscal incentives discussed above.
If you find your sole proprietorship is experiencing a situation similar to that of Jay, Sara, and Julie think about how incorporating your business could help you out**.
**We recommend consulting an expert Lawyer or Accountant to determine whether to incorporate federally or provincially.
*No Legal or Finance Advice. We are not your lawyers or accountants.*
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