Starting a new business is challenging and exciting. Which type of business entity you choose will impact the way you maintain your records, the expenses that can be deducted and many other tax related implications.
The most common types of business structures are sole-proprietorship and corporation. Let’s look in details in advantages and disadvantages of them.
Sole Proprietorship.
Starting business as a self-employed requires minimum registration and government filing. A person who wishes to operate as a sole proprietor under his name (i.e. John Smith) does not have to do any business registration. If you want to operate under a fictitious name a business name should be registered. In Ontario the business name should be renewed every five years. Business name can be registered online through the government service One-Source for Business.
Registration with Canada Revenue Agency may be required as well. If your sales exceed $30,000 per year you must open HST account. You may wish to open HST account even if annual sales are below the threshold.
Payroll account will be required if you are going to hire employees.
Your business might be required to register with WSIB if you hire employees or contractors without WSIB clearance. Construction industry has specific rules regarding mandatory coverage.
Taxation of self-employed income.
Self-employed income is taxed at graduate tax rates at your personal level. Statement of Business or Professional Activities is included in personal tax return (T1 General). Tax deferral options are very limited. The income is subject to CPP premiums.
Loss from self-employed business is deducible from your other income (i.e. employment, investment). The loss is generally available for carry back 3 years and carry forward for 20 years.
Example 1: John is employed and received $70,000 salary in 2018. John started sole proprietorship and incurred losses of $20,000 in 2018. The loss will be deducted from salary and John’s total income (Line 150) would be $50,000.
Example 2: Margaret started sole-proprietorship in 2015 and incurred loss of $45,000. She had no other income in the year. Margaret may carryback the loss up to 3 years (Years 2014, 2013 and 2012) if she had taxable income. Prior year tax returns will be readjusted and a refund will be issued. Assuming Margaret did not have any taxable income in preceding years she would be available to use those losses in the next 20 years.
Income splitting in a sole-proprietorship business is limited. Payment of dividends is unavailable in this type of business structure. You may pay reasonable salaries to your family members but they have to do work and very likely you will need to set up payroll for them.
Liability
Generally, sole-proprietor has unlimited personal liability related to business affairs of the sole proprietorship. Personal assets might be lost if litigation arises.
Corporation.
In order to commence business through a corporate structure an entrepreneur has to file Articles of Incorporation. Filing can be done under provincial or Federal level. Various classes of voting and non-voting shares can be set up.
Same rules for WSIB, HST and payroll account registration apply as for sole-proprietors.
Taxation of Corporation.
Corporation is a separate legal entity and it files its own corporate tax return (T2). In Ontario, Canadian Controlled Private Corporation pays 15% corporate tax on its first $500,000 of active business income. Income can be distributed to owner-manager in form of a salary or dividends. Family members may receive dividends if they own any shares of the corporation. No work should be performed in order to receive the dividends. No dividends can be paid to minor children.
Corporate structure allows deferring personal income by controlling timing of dividends withdrawal and splitting personal income between calendar years. Also, dividends are not subject to CPP premiums.
Losses incurred in the corporation are not available for use at personal level. The losses are available for carry back 3 years and carry forward for 20 years against taxable income of the corporation.
Liability.
Generally, shareholders cannot be sued personally for business affairs of the corporation. Directors can be personally liable for unpaid HST, payroll remittances and WSIB premiums.
Conversion of Sole-proprietorship into Corporation.
It is possible to start a business as sole-proprietorship and later to rollover in in corporation. Certain tax filing should be done to avoid tax on deemed disposition. The new corporation will have to obtain new HST, payroll and WSIB registrations and bank accounts. In the year of the rollover you will need to keep two separate accounting records; one for the sole-proprietorship and another for the corporation.
Summary.
Sole-proprietorship.
Advantages:
Simple and inexpensive set up
Combined tax filing with personal tax return.
Disadvantages:
Difficult income splitting
Limited tax deferral
Unlimited personal liability
Corporation.
Advantages:
Income splitting potential
Tax deferral options
No personal liability for shareholders
Disadvantages:
Fees to set up
Separate tax filing is required.
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