Most entrepreneurs dream of creating big businesses, and this is often synonymous with incorporating. While the corporation is one of the most common and versatile business structures, there are times when you may want to avoid or delay incorporation to improve after-tax profits.
A sole proprietorship is where one person operates a business without forming a corporation. All benefits that arise from the business accrue exclusively to the sole proprietor. Establishing a sole proprietorship is relatively simple, and the cost to register and maintain it is low. The name of the sole proprietorship must be registered under the business name legislation in each province where the proprietor carries on business, but there are few other registration requirements.
From a tax perspective, the income or loss of the business is added to all other sources of income of the sole proprietor and taxed at his or her personal income tax rate. This is ideal if the business is in its infancy and incurring losses. If the sole proprietor has other sources of income, this loss can be “written off” against other sources of income. This cannot be done if the business was operating as a corporation.
There are, however, risks for the sole proprietor. Because the proprietor operates the business personally, all obligations and liabilities are his or her responsibility. Likewise, the proprietor could be responsible for any improper acts of employees. If the business is sued, all assets of the sole proprietor, including personal assets, are liable to be seized to satisfy any obligation of the business. These liabilities can be eased if the sole proprietor obtains insurance or uses contracts to limit liability. Still, it can be a concern
If the business is profitable, the income will be added to other sources and the sole proprietor will probably be paying higher taxes than if the business were operating as a corporation. For example, active business income earned by Canadian controlled private corporations (CCPC) can be taxed at a lower rate.
Another difficulty for sole proprietors is succession planning. When the owner dies, the business also ceases to exist. While the assets of the business pass on to the sole proprietor’s heirs, leases and contracts may not be assumable. This could prevent the successful continuation of the business and can be a difficult hurdle to overcome.
Additionally, the sole proprietor may face problems raising additional capital necessary for the continued success and expansion of the business. The business only has the capital the sole proprietor can contribute or borrow personally. Lenders may require security against the sole proprietor’s personal assets.
So what is one to do? There are risks and rewards in operating as a sole proprietorship. One successful strategy is to continue to operate as a sole proprietorship, reaping the income write-off against all other sources of income, until the business is making money. At this stage, the sole proprietor would form a new corporation (NewCo) and use a rollover to transfer the assets of the sole proprietorship into NewCo (a rollover is a tax strategy that minimizes or defers capital gains tax that would arise merely because of the transfer into the corporation). The sole proprietorship can assign its name to NewCo (but with Inc., Ltd. or Corp. at the end). Thus, the goodwill and name recognition of the sole proprietor can be continued with NewCo.
NewCo can be funded in whole or in part by issuing shares. This often includes shares to a spouse and children, with different rights and attributes that can be beneficial in tax planning. Additionally, shareholders can lend money via a shareholder loan to NewCo. As NewCo becomes more profitable, the loans might be repayable without attracting income tax.
If NewCo earns “active business income” as defined in the Income Tax Act (Canada), and is deemed a CCPC, then NewCo can avail itself of the small business deduction available to reduce the corporation income tax payable. There will be additional tax payable when the money is distributed to shareholders, but there is at least a deferral, and other tax planning opportunities can increase the benefit.
In summary, it may be beneficial to structure your new business as a sole proprietorship, at least at the outset. When the business becomes more successful, roll the assets into a new corporation. This maintains the benefits of a sole proprietorship until your business is at a stage where it can fully benefit from the advantages and protection of a corporation. It also helps to keep costs down, especially during the all important start-up phase.