Incorporating a business can offer a slew of advantages to small-business owners, including major tax savings. But tax experts say the corporate structure is not an ideal option for all.

Determining whether to incorporate involves many considerations, but the potentially significant tax savings is the primary reason business owners go this route, says Myron Knodel, a tax and financial planning expert with Winnipeg-based Investors Group Inc.: “The advantage can be significant.”

The primary tax advantage of incorporating is derived from the lower tax rate on the income that the business generates. The first $500,000 of income that a Canadian-controlled private corporation generates is taxed at combined federal and provincial rates ranging from 12% to 19%, depending on the province. This compares with a combined federal and provincial personal income tax rate that can reach 46% for income in the highest bracket, paid by sole proprietors on the profits their business generates.

Given the big difference between the tax rates facing corporations and sole proprietors, the potential tax benefits of incorporating a business are clear. But these savings are not attainable in all circumstances. In fact, tax experts warn, they are dependent upon several factors that business owners should consider before making a decision.

A key consideration is the profitability of the business. Typically, it does not make sense for a business that’s losing money to incorporate, says Allison Marshall, a financial advisory consultant with RBC Wealth Management Services in Toronto. Although sole proprietors are able to deduct losses against other sources of income, losses in an incorporated business cannot be flowed through to shareholders. “I would generally say to my clients,” Marshall says, “that they wouldn’t want to look at incorporating until they’re generating a profit.”

Business owners must also realize that they will be able to achieve tax savings from incorporation only if most of the income generated remains in the company, Knodel says: “The tax advantage occurs when you are in a position in which you can retain after-tax income in the corporation.”

If incorporated business owners depend on a significant portion of the income generated for their day-to-day needs, they would likely end up paying taxes at a rate roughly equivalent to the personal income tax rate.

“There are generally no tax savings [in this situation],” Marshall says, “because as soon as you take the money out of the business, it’s taxed on your personal tax return, so you’re back to square one.”

As a result, the costs of setting up and maintaining the corporation could outweigh the ultimate tax benefits in such a situation.

But business owners who retain income in their corporation do not necessarily have to use the earnings in the business. The money could be placed in any type of investment, Knodel notes, as long as it is owned by the corporation.

Business owners considering incorporation must also think about the costs involved. Establishing a corporation initially costs about $5,000, including legal and accounting fees, says Knodel. But, he warns, these costs vary depending on the lawyer and the complexity of the corporate structure. Once the business is incorporated, there are ongoing costs related to the preparation of financial statements, record-keeping and filing a separate corporate tax return.

But often, the resulting tax benefits are well worth the costs, Marshall says: “Generally, the advantages of incorporating outweigh the costs.”

These advantages extend beyond the savings derived from the lower corporate tax rate. For example, the owner of a corporation can also engage in income-splitting with family members to reduce taxes. This can be achieved when a member of the owner’s family, who is over the age of 18 and in a lower tax bracket, becomes a shareholder in the firm. That relative could then receive dividends from the corporation to prevent all the income from flowing to the business owner.

“Rather than have the income from the business all taxed in your hands,” Knodel explains, “it’s possible to have some of that income taxed in their hands, at lower rates.”

This strategy could be especially advantageous for business owners who have a spouse with no other sources of income, Marshall says, as the spouse could receive annual dividend income up to approximately $30,000 on a tax-free basis.

For business owners who pay themselves a salary, the corporate structure presents additional benefits. In particular, business owners saving for retirement have the option of setting up individual pension plans if their business is incorporated. This vehicle, which is a type of defined-benefit registered pension plan, has a higher contribution limit than do RRSPs, which could allow the business owner to accumulate a significantly larger pool of tax-deferred retirement savings, Marshall says: “The idea is that you have more money growing in the plan.”

@page_break@Incorporation also offers tax-related perks for business owners who plan to sell their company. When a business is incorporated, the owner could qualify for the $750,000 lifetime capital gains exemption. So, if the owner sold shares in the company, up to $750,000 of the gains from the sale could be received tax-free.

If family members hold shares in the business, the tax savings could be even more significant, because the exemption applies to each shareholder, Knodel says: “When you’re setting up your share structure, if you feel that the value of the business is going to go way up, maybe having some shares in your spouse’s or a child’s hands would allow you to multiply that exemption.”

Beyond the tax considerations, another common reason business owners decide to incorporate is to limit their personal liability.

“If you’re carrying on a business in an unincorporated form, the risks are that the potential liability of that business effectively becomes your own personal liability,” Knodel says. “If, however, your business is being carried on within a corporation, the risks of that business, and the creditor claims that may result from that business, are limited to the assets of the corporation.” IE