Legal structure – getting the most out of your small business

A sole proprietorship occurs when an owner operates a business with no other form of business organization. This type of structure is simple and can easily be created with a few government forms. In most provinces there is a small registration fee – in Ontario, it’s $60 to register your business and this is valid for 5 years.

A corporation is a separate legal entity that is registered as such under Canadian law. The owner(s) of the corporation are known as shareholders and do not directly own assets of the corporation nor are they responsible for the debts of the corporation.

If there are two or more individuals that own the business, a joint partnership can be set up, which operates similarly to a sole proprietorship. Recently in Canada, limited liability partnerships allow for some liability mitigation but for the purpose of this article, we will discuss sole proprietorships and corporations.

Professional fees

Professional fees for a sole proprietorship are fairly minimal. Depending on the size of the business and the number of transactions the owner may be able to pay very little (if anything) in fees to accountants or lawyers. Sole proprietorships typically have the following government reporting requirements:

  • Initial business registration
  • Annual personal tax returns (T1)
  • Payroll remittances and filings (if additional employees exist besides the owner)
  • Sales tax (if registered for GST/HST)

A corporation will usually be subject to higher professional fees as the average shareholder likely will require support for the additional accounting and legal requirements. The initial start-up for a corporation may require a lawyer to obtain articles of incorporation, set a corporate share structure and additional consultations. It is possible to incorporate a business online federally via the Canada’s Corporations website, which is approximately $250. The fee to incorporate in most provinces ranges from $300-$400, depending on the province. Incorporating federally will allow for greater name protection when operating nationally, however, it requires additional filings each year as well as individual provincial registrations. These costs are baseline and do not include any legal consultation which will add at a minimum a couple of hundred dollars to thousands extra. Despite the potentially high costs I highly recommended a competent lawyer be consulted when setting up a corporation given that it could save large headaches down the road.

Aside from the legal startup costs, a corporation will probably incur higher accounting fees for additional government regulations compliance, bookkeeping and tax planning. Corporations may be subject to, but not limited to the following reporting requirements:

  • Setting up articles of incorporation
  • Annual information return – this is a brief return that details information about shareholders and general information about the corporation
  • Maintaining corporate records, which are separate and distinct from personal records (must be held for 6 years per CRA regulations)
  • Filing an annual corporate income tax return which includes detailed financial statements
  • Payroll remittances and filings (if the corporation has employees)
  • Sales tax – if sales of the corporation exceed $30k you must register for GST/HST and track sales tax spent and collected

The nature of the above reporting requirements becomes more complex with the operational size of the corporation. (Tip: Regardless of your corporate structure to minimize accounting fees keep ongoing organized financial records. Avoid paying your accountant $100/hour+ to sort through your shoebox of receipts)

A corporation requires a T2 annual tax return to be filed in Canada with the CRA. This filing requires a set of financial statements along with other information about the corporation. It is a good idea to have an accountant prepare this filing to ensure the accuracy and completeness of the information. Depending on how well your records are organized and the complexity of the financial transactions this will cost at anywhere from $1,000 plus per year.

Often I see small business owners of both sole proprietorships and corporations attempting to skimp out on paying professional fees. Having run my own small accounting business myself, and having provided tax planning services in an accounting firm, I understand the value of these services is often difficult to quantify or justify, especially considering the cost of professional fees. However, I’ve also seen situations where personal and corporate bank accounts have been frozen by the CRA for non-compliance, or an unexpected tax bill cripples cash flow because these issues were neglected. There can be tax-minimizing opportunities lost (such as tax deferral, income splitting and other deductions) by business owners when they fail to engage a competent accountant. Paying a competent professional can ensure a business handles these issues before they become massive problems.

Tax strategy

A sole proprietorship operates under the owner and all income and expenses are claimed on his/her personal T1 tax return on an annual basis under a T2125. The effective tax rates for 2014 in Canada are as follows (I’ve used Ontario provincial rates here for the purpose of this discussion):

$8,044 in tax on the first $40,120 earned (20% tax rate)

$9,242 in tax on the next $30,531 earned (30% tax rate)

$6,063 in tax on the next $17,256 earned (35% tax rate)

After you’ve earned over $90k you’re looking at approximately 40%-50% tax on each additional dollar earned. Our tax system works like this to provide lower tax rates to low-income earners and higher rates to higher-income earners (in theory).

At the end of each year you add up all the business revenue you earned in the year and subtract all the related expenses (note: you can deduct non-direct expenses such as office and vehicle expenses of a business on a pro-rated basis). The net income (earnings less expenses) is then used to determine the amount of tax you owe. For example, if you earned $50,000 and had $30,000 in expenses for a net income of $20,000 you would have a tax bill of approximately $4,000 [($50,000 – $30,000) x 20% tax rate].

The corporate small business tax rate in Ontario is 15% on the first $500,000 of income. Sweet sassy molassy, that’s way lower than the personal tax rates above. Why doesn’t everyone just incorporate? I know, right? Well, hold on there that rate is for income earned in the corporation and it must stay there until paid out to the owner via salary or dividends. This is where tax planning comes into play and can drastically affect your take-home pay if you’re earning some decent money. Here’s an example of a business earning $100,000 in income under a sole proprietorship versus a corporation.

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