When Is It Time to Incorporate My Small Business?

Many small businesses start out as side projects.  

Your friend knows you’re into photography so she asks you to do her engagement photos. Next thing you know, you’re getting a bunch of requests from friends of friends to be the photographer at their events. A year goes by and you’re booked up almost every weekend now for various photography engagements. Finally you decide to quit your day job and go ahead with your photography business full-time.

So now you’ve been running your photography business for 3 years and you’re making some descent money.  You know that many businesses incorporate at some point, but just when do you know it’s time? Before we can answer that question, let’s look at why businesses incorporate.

The main legal reason that businesses incorporate is limited liability.

In a corporation, the liability of an individual shareholder is limited to the amount of money he/she has invested in the company. If you invested $10,000 in the company to purchase top of the line photography equipment, that’s the extent of your liability (there are exceptions to this but let’s keep it simple).

If you get sued by your Bridezilla client who claimed you ruined her wedding, your at-risk amount will only be $10,000.

As an unincorporated entity, all your personal assets would be at risk – Bridezilla could go after your house, car, personal bank account, etc.

From a tax perspective, incorporation has some real benefits.

The main tax benefit stems from the fact that the corporate tax rate is much lower than the personal tax rate. If you were to earn $150,000 personally, a portion of the earnings would be taxed at approximately 46%. If the same amount was earned in a corporation (assuming you’ve earned less than $500K), the company would pay about 16%[1].

This difference in tax rates allows you to take advantage of tax deferral.

For example, suppose your photography business is now earning $150,000 per year. However, you really only need $80,000 for your living expenses throughout the year. You can choose to only take out $80,000 from the corporation, paying less personal tax now and deferring the rest of the tax later on when you choose to take out the rest of the money.

If you weren’t incorporated, you would have to pay tax on the full $150,000 now.

Not only can you decide how much money to take out of the corporation, but you can decide how you would like that money.  The two main ways of taking out money from a corporation are salary and dividends.

Due to the favourable tax rates on dividends, you can take out almost $50,000 of dividends without paying any tax.

There are obviously some pros and cons of doing so (see salary vs. dividends), but for now, let’s imagine that the company earned $50,000 and you took them out as dividends. The company pays approximately 16%[1] on the earnings, and you take them out virtually tax free. If you had earned the money personally, you would be paying about 20%[1] in tax. That’s an extra $2,000 in your pocket.

The savings are far greater if you can take advantage of dividend splitting.

Let’s assume you have a family and since your photography business is doing well, you’re the breadwinner. Now let’s say that you want to take out $150,000 from the business. If you take it out the full amount as dividends, you may pay about $30,000[1] in taxes.

However, if you make your spouse and children shareholders of the corporation, they can take out a portion as dividends. So instead of you taking out the full $150,000, you take out only $50,000, your spouse takes out $50,000 and your 2 children take out $25,000 each.

You may have just saved yourself $30,000 (there are some other factors to consider here, but the tax savings are clear).

While there are a number of benefits associated with incorporating, there’s also a number of costs associated with it. As an incorporation, you’ll have to file a separate tax return called a T2 in addition to your personal tax return. Your record keeping will become a little more involved as well so you’ll want to make sure you get the proper accounting software to handle it. There’s also some additional paperwork as the corporation must maintain a minute book and keep up to date records of the directors, share register and articles. In short, you’re looking at increased legal and accounting fees.

So let’s get back to our original question. How do you know it’s time to incorporate your small business?

Well, from a legal perspective, if you’re operating in a high-risk industry, that is, with a high likelihood of being sued, you may want to incorporate from the get-go. If you’ve got a construction company, your chances of being sued are probably higher than if you’ve got a photography business. In that case, you may want to incorporate even before you can take advantage of the full tax benefits of corporations in order to protect your personal assets.

From a tax perspective, there is no magic number of earnings that says when you must incorporate.  

Basically, if your business is earning more than you need to match your lifestyle, you’ll be able to take advantage of tax deferral. For some people, if your business is earning over $100,000, incorporation will probably make sense for you. The tax dollars saved from tax deferral, dividend splitting or favourable tax rates on dividends will likely be greater than the additional legal and accounting costs.

Still not sure if incorporating is worth your while? Speak to your accountant or email me at josh@liveca.ca and see if it makes sense for your business.

[1] Tax rates will differ slightly depending on the province and year.