Why Incorporate?

(updated November 2007)

by Del Elgersma

A common question asked by entrepreneurs starting a business is "Should I incorporate?" The most common answer is: "It depends".

A business is owned either as a proprietorship, a partnership, or a corporation.

Proprietorship

A business owned by one individual (a "sole proprietor") is a proprietorship. This is the simplest form of business structure, as it may only require a municipal business license and the registration of the business name (unless it is the proprietor's own name) with the provincial government (this does not protect the name!). The proprietor is personally responsible for all of the liabilities of the business, and all of the income and assets of the business belong to the proprietor.

Partnership

If a business is owned by more than one individual it is a partnership. Partners are personally and jointly responsible for the debts of the business, and any partner can create a binding obligation of the business. Profits and losses are shared equally, unless otherwise agreed. Losses can be deducted from the personal taxable income of the partners. Partnerships for "trading, manufacturing or mining" are required to register with the provincial government under the Partnership Act.

Limited Partnership

A "limited partnership" is a special type of partnership often used to raise money because investors, as limited partners, are responsible for the liabilities of the partnership only up to the amount of money or property they contributed to the partnership (unlike a regular partnership where every partner is personally responsible for the full amount of the partnership's liabilities). A limited partnership is created only after extensive information is filed with the provincial government.

Corporations

Incorporation is the act that creates an entity known as a corporation, or limited company (the term "company" usually means a for-profit corporation, while the term "corporation" includes other types of legal entities, including non-profit societies).

A company is owned by its shareholders and managed by its directors and officers. It is possible, and very common, for one person to be the sole shareholder, director and officer.

The benefits of incorporating your business include:

1) Limited Liability

One of the most important benefits of incorporation is limited liability. If you incorporate your business, your company is responsible for the debts and obligations of the business. As a shareholder, you are not personally responsible if your company cannot pay its debts or is sued by a customer.

However, if you signed a personal guarantee of the company's lease, bank loan, or other indebtedness, you will lose this benefit for those obligations. Further, a judge may strip away the limited liability protection (called "lifting the corporate veil") if you do not treat the company as a separate entity, or do not observe certain legal formalities such as documenting annual meetings. In addition, if you are a director of the company, you can be personally responsible for unpaid wages, GST, payroll deductions, WCB assessments and other amounts.

2) Tax Advantages

Corporate tax rates are generally lower than personal tax rates. Most privately held companies earning active business income will pay tax of approximately 17% on the first $400,000 of taxable income compared to over 40% if the income was earned by an individual in the top marginal tax bracket. It is important to note that this is for the most part only a tax deferral. You will pay taxes at the personal tax rates when you take money out of the corporation.

A company allows for maximum flexibility in tax planning. For example, you can decide when to pay dividends to the shareholders, and which shareholders will receive dividends. As well, the $750,000 capital gains exemption on the sale of a small business is only available on the sale of shares of a qualifying company and not on the sale of a proprietorship or partnership. If the shares qualify for the exemption, the first $750,000 of capital gains is exempt from tax.

3) Access to Capital

Proprietorships and partnerships can only raise capital by borrowing, from themselves or others. A company can raise capital by those methods, but also by selling shares. Although this involves giving up some ownership of the company, shares offered to investors (including employees) can be tailored so that you maintain control of the company. You may not sell shares to the public unless you file a prospectus or offering memorandum with the B.C. Securities Commission.

In addition to having more options for raising capital, companies may have an easier time raising capital because they are often seen by investors and lenders as having more credibility.

4) Perpetual Existence

Unlike a proprietorship or partnership, a company does not cease to exist on the death of its owner(s). Instead, it continues to live on, with ownership transferred to the shareholders' heirs. Many Canadian companies are well over 100 years old. The ability for a company to continue beyond the life of its owners can give a business greater stability, allowing it to plan over a longer term and have easier access to capital.

Disadvantages of Incorporation

If you are starting a business, it might not be a good tax strategy to incorporate right away. If your business loses money in the first few years, you can use your losses to offset your other income or even recover personal income taxes paid in previous years. On the other hand, if you incorporate your business the losses stay in the company where they can only offset the corporation's future profits. If the company is never profitable you will miss the chance to deduct the losses.

Incorporation also involves extra legal and accounting costs, although the lower corporate tax rates and greater ability to raise capital may offset these costs.

Canada v. B.C.

If you do choose to incorporate your business, the next decision is to choose the jurisdiction of incorporation. The vast majority of B.C. companies are incorporated under provincial jurisdiction, but with the growth of the online economy and "globalization", more and more entrepreneurs choose to incorporate federally. Each jurisdiction has its pros and cons.

Heightened Name Protection for Federal Corporations

One of the most common reasons for choosing to incorporate federally is the increased name protection given to federal corporations. While all provincial jurisdictions screen potential corporate names, Corporations Canada applies the most stringent tests before granting the right to use a name. This guarantees that, once incorporated, the name has a protected status second only to trade-mark protection.

Extraprovincial Registration

Whether you have a federal or a B.C. company, it must be registered in each province in which it carries on business. This means that a federal company that operates in B.C. must incur the extra expense of registering in B.C. On the other hand, a federally incorporated company has the constitutional right to carry on business anywhere in Canada under its own name. A B.C. company does not have this right. If a B.C. company wants to expand to another province and another company with a similar name already exists in that province, the B.C. company will have to register in that province under a different name.

If you are considering opening a business, or have already done so, call us to discuss your options.