New Business: Should You Incorporate or Run a Sole Proprietorship?

Starting a new business? One of the most important and earliest decisions you need to make is how to structure it. This is not as exciting as creating a new product or chatting with potential customers – but it can have a huge impact on your business.

Sole proprietorship vs. Corporation

In Canada, a sole proprietorship is connected with you personally. You report any net income directly on your personal tax return. You are responsible if your business is sued. On the other hand, a corporation is a separate legal entity with limited ability. It can have other shareholders in addition to yourself.

Tax implications

There are different tax rules for a sole proprietorship and corporations. As indicated, with a sole proprietorship you simply report your net income on your Canadian tax return. During startup, you may have some business losses that you can write off. If you have other income, such as from employment, this will reduce your taxable income.

Over the long run a corporation may offer more tax benefits. You have the option of holding income inside the corporation instead of distributing it as a salary or dividend. Corporations are taxed at a lower rate than individuals, so you may pay less tax.

In addition, you can structure your company so that both you and your spouse are shareholders, allowing you to split any income through dividends. The corporation can pay a salary to your spouse provided he or she does actual work in the business.

With a sole proprietorship, you must automatically include any income on your personal tax return. So you will pay tax on that income.

The risks of a sole proprietorship

The biggest risk with this structure is liability. You are personally liable for any debts or legal liabilities arising from a lawsuit. Your house, savings and other assets can be seized to pay for these obligations.

Secondly, sole proprietorships offer less flexibility. Since you cannot offer shares in a sole proprietorship, it can be difficult if you want to raise capital through investors. When you retire, it can be hard to sell a sole proprietorship since the major asset is essentially you. On the other hand, it’s relatively easy to sell the shares of a small business corporation, assuming that you can find a buyer who is interested in taking over your business. 

The cons of a corporation

Corporations are more costly to set up and operate than a sole proprietorship. Provincial governments charge incorporation fees and you will need a lawyer to assist you with establishing the company. You will likely need an accountant to file your corporate tax return and a lawyer to record your annual resolutions.

Which structure is best for your business?

Sole proprietorships are well-suited to low-risk consulting businesses, freelancers and others who work from home. On the other hand, a corporation will work better if you expect to have employees some day or hope to build your business into a valuable asset that you can later sell to investors.