Many people, myself included, have started side hustles to either pursue a hobby or supplement our main sources of income. As your side hustle grows, however, you may start asking yourself this question: Should I and Why should I incorporate my business? As a small business owner, what are the advantages and disadvantages of incorporation, and what are the key ideas you need to make a decision? Read more to find out!
Advantages of incorporating
Incorporation comes with numerous benefits that are not available if you operate your side hustle as an individual. Here are the key advantages:
Limited personal liability and asset protection
A corporation is a separate legal entity. It has its own business name, business debts, assets, and so on. By having a separate legal entity, you are protecting yourself against lawsuits against your company. In case of a bankruptcy of your corporation, your debtors will not be able to come after your assets and personal property.
This is another key advantage that comes with a corporation. When you are earning income with your side hustle, you need to include all the income on your personal tax return. While you can pay your spouse or children a reasonable salary if they do work on your side hustle, the income splitting opportunities are limited if you operate your business as a sole proprietor.
This is not the case if you own a corporation. In addition to paying your spouse or children a salary (provided they work for the corporation), you can also pay dividends to them if they are set up as the shareholders of the corporation.
Note that because there have been cases of people abusing the income splitting opportunities, the governments have placed more restrictions. Please consult a tax professional to make sure that you are not violating any limitations; otherwise, you may pay even more taxes or even be penalized.
Possibility of tax deferral
It is also possible for you to defer your tax obligations until a future year with a corporation.
For example, you have the option to choose to defer dividend payments until a future year when it is more tax advantageous for you to withdraw the money from the corporation (e.g., a taxation year where you have less income and therefore are subject to a lower personal tax rate).
Tax savings through lower tax rates
The government is incentivized to give tax benefits to corporations. Their rationale is simple: corporations create jobs, and jobs help lower the unemployment rate and boost the economy. They also want corporations to use the money to re-invest in their business so they can keep growing.
As such, income left in the corporate has a lot of tax advantages. The corporate income tax is usually lower than that for individuals. For example, in Canada, there is a small business deduction. If you qualify, your corporation pays as low as 9% federal tax instead of as high as 33%, which is the highest tax bracket for an individual.
Note that if you pay yourself a salary from the corporation, then the salary is subject to individual tax systems (15%-33%, depending on your other income).
Estate planning and succession
If you run a sole proprietorship, then from a legal and tax perspective, you are not distinct from your business. You are in direct control of your business. This makes it difficult should you want to pass on your business to your children or someone else.
A corporation, on the other hand, is a legal entity that is separate and distinct from its owners. It also has unlimited life. As such, if you want to pass on your business to another person, whether he/she is your heir or not, you may want to consider incorporating your business.
Capital gains exemption
Should you decide to sell your business, you may qualify for capital gains exemption. This means that up to a certain limit, you do not have to pay capital gains tax on the amount paid. This is a huge advantage compared to a sole proprietorship.
For example, if you run a successful blog that can be sold for CAD$500,000. If you do not have a corporation, you will have to include the full CAD$500,000 on your personal tax return in the year your blog is sold. Assume you do not have any other sources of income in that year, you will have to pay around $140,000 in taxes. If you have a corporation, however, you may utilize your lifetime capital gains exemption, and you may not have to pay any taxes on the entire $500,000!
Disadvantages of incorporating
Of course, incorporation isn’t all rosy and beautiful. Alongside the benefits also come disadvantages.
Incorporation is more complicated. Because it is a separate legal entity, it will require that you file annual reports, including a full set of financial statements. You will also need to maintain a completely separate set of bank accounts just to keep your personal financial records separate from your corporation.
It is expensive
Forming a corporation is a lot of work. Because of all the extra requirements, scrutiny, and additional record keeping that come with a corporation, it is also more expensive than a sole proprietorship to set up and manage. If you do not have the necessary accounting background, you may need to rely on a tax professional to file your annual tax returns and to help you navigate questions your government tax agencies and banks may throw at you. Professional tax services, especially for corporations, are not cheap.
Additionally, business entities like limited liability companies (LLCs) and corporations must name a registered agent to receive legal communications and other documents on behalf of the business. A business may name an owner or employee as the agent. But in many cases, you may want to use a professional company that provides registered agent services. This comes at an additional cost.
Not being able to offset losses with personal income
Because there is no legal distinction between a sole proprietorship and an individual, if there are any losses in the sole proprietorship, you will be able to use your own income to offset them. The overall effect is that you will pay less tax overall.
If you have a corporation that has incurred losses, however, you will not be able to use your other income to offset them. Your corporation’s losses can only be used to offset future income generated by the corporation.
This is a key reason why many people choose to start a business first as a sole proprietorship and later transition into a corporation.
Note that regardless of whether you choose to incorporate or not, you can always deduct relevant business expenses when calculating taxable income. Relevant business expenses include operating expenses, payroll, health benefits paid to the employees, and so on.
Conflicts among shareholders
Corporations are naturally harder to manage than a sole proprietorship, especially in the case of multiple shareholders. Each shareholder has his/her opinion, and it is much more difficult to agree if there are many decision-makers in the room. Not being able to manage conflicts well can directly lead to the detriment of the business.
What are the similarities and differences between a corporation and a limited liability company?
Thinking to incorporate a business? As you search the internet about “why should I incorporate my business”, you may have come across the concept known as a limited liability company (LLC).
A limited liability company is the US-specific form of a private limited company. It is a business structure that can combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation.
Similarities (LLC vs. corporations)
LLCs and corporations are considered “domestic” only in their state of formation and foreign in another state. Consequently, both LLCs and corporations must foreign qualify in any other state where they conduct business. States require “out-of-state” businesses to register so consumers can be protected.
Both LLC and corporations provide a separation between personal and business. As such, you can use either vehicle to protect your personal assets.
Differences (LLC vs. Corporation)
Ability to issue shares
The main difference between an LLC and a corporation is that an LLC is owned by one or more individuals, and a corporation is owned by its shareholders. LLCs cannot issue shares, and thus do not have shareholders. Rather, they have owners who are allocated a percentage of the company according to the LLC’s operating agreement.
As well, a corporation is a universal concept. You can for a corporation in most places around the world. LLC, on the other hand, is a US-specific entity. Such an entity is not always available in other countries (e.g., Canada doesn’t have a corresponding structure).
A corporation exists in perpetuity separate from the owners. Even when an owner leaves or divests from the company, the corporation remains in existence.
On the other hand, by default, if not defined in the operating agreement, when a member leaves, the LLC it must be dissolved. However, you have the flexibility of outlining the details about how membership interest can be transferred between its members, if at all, and what happens when a member leaves the LLC.
This is a unique issue for businesses that are structured as C corps (and LLCs that elect to be treated as corporations). The business profits for these organizations are taxed twice. The corporation first pays taxes on its profits, but then stockholders must pay personal income taxes on the dividends paid from the company’s after-tax profits.
When should you consider incorporating your business?
Now that we know the advantages and disadvantages of incorporation, let’s talk about when you should consider incorporating a business.
When you are making sufficient income
As I mentioned before, if you have a corporation, you cannot use your personal income to offset the losses. Of course, if your corporation is already generating money, this becomes a non-issue.
As well, you should be able to afford the tax services that will likely be required when you have a corporation. You may want to make sufficient income to be able to cover the cost first before considering this option.
If your business is earning more than what you need to maintain your current lifestyle, then incorporation is certainly worth considering because of the tax deferral opportunities.
When you have incurred business debt and you have substantial personal assets that debtors can come after
This is a very important reason why you may want to incorporate your business from the get-go. A corporation structure helps protect your personal assets. If you have debtors (e.g., you run a capital-intensive business), you may want to set up a separate legal entity. This way, you are protected in case of lawsuits against your company, and you won’t be personally liable in most cases.
Note that under certain circumstances, you, as the director of a company, may still be found personally liable. These include GST/HST remittance, unpaid wages, etc.
When you want to eventually sell your business
As I mentioned before, you can use your lifetime capital gains exemption to save yourself quite a lot of tax dollars if you sell your business as a separate legal entity.
Of course, when you first start your business, you may not know whether you will sell your business. You may want to run your business as a sole proprietorship first and incorporate later. You are allowed to incorporate immediately before you sell.
When you want to issue shares
You may want to issue stock to shareholders, who can then transfer shares, purchase more stock to own a larger percentage of the company, or sell off stock to own less.If you want to raise capital from outside investors who don’t necessarily have a personal relationship with you, it is much easier to use a corporation as the vehicle.
Incorporating a business is a major decision. Whether you should incorporate your business ventures or not largely depends on where you are with your journey. I currently operate my blog as a sole proprietorship. Although there are many benefits associated with a corporation, for me, it is not worth the complexity just yet.
However, as my blog continues to grow, I hope one day I will be able to incorporate my side hustle and set it up properly as a corporation. Watch me!