It comes with a lot of costs, while sole proprietorship offers many tax writeoffs, expert says
Ray Turchansky
Sun
CREDIT: Greg Southam, Edmonton Journal Jim Yih, of Core Financial in Edmonton, says with a partnership owners can spread the risk and have greater access to capital. But he advises protecting yourself.
The first and often most important questions people ponder when starting up a small business are which structure to pick and how to pay themselves.
Basically there are three structures –sole proprietorship, partnership and incorporation — and each has its pros and cons.
“I think there’s a real perception that incorporation is so much better, and I think people have to be very careful about that perception,” said Jim Yih, of Core Financial in Edmonton.
“There are a lot of times when incorporation doesn’t make sense right off the start. A lot of times people should try the sole proprietor route just to see if it’s successful, because there are lots of costs with incorporation. People think you’re getting all these tax benefits, but you’re getting a lot of tax benefits with sole proprietorship in terms of write-offs.”
Sole proprietorship and partnerships are similar in that the owner or owners assume unlimited liability for company operations, and the structures have no legal status.
Advantages include low start-up, legal and accounting costs, plus little government regulation. Disadvantages include unlimited personal liability for the debts and obligations of the business, difficulty in raising capital, little flexibility in paying yourself, and few options for succession.
With a partnership, you can share skills, spread the risk of the business, and have greater access to capital. Conversely, there can be disagreements in the running of the business and disbursing profits, as well as difficulty in getting rid of a partner and dealing with succession.
“Make sure that you walk into it with your butt protected,” said Yih. “I see more problems with partnerships, because at the end of the day it’s very difficult to make things equal, and sometimes equal isn’t fair.”
A corporation is a separate legal entity with an unlimited life expectancy. The major attractions are that debts and liabilities are usually limited to corporate and not personal assets, and that tax can be deferred using lower corporate tax rates.
Yih notes that while incorporation may limit liability in the case of lawsuits, “if a corporation is borrowing money from an institution, they require a personal guarantee anyway.” Furthermore, members of a corporation’s board of directors may be open to legal charges.
Among disadvantages are the legal fees to set up a corporation and accounting costs to prepare annual corporate financial statements and tax returns. Costs usually start at around $1,500 and can quickly become tens of thousands. Also, non-capital losses can only be carried back three years or forward seven years to be claimed against business profits, thus they may become trapped within the corporation. On the other hand, proprietorship or partnership losses may be claimed against personal income.
Profits earned by proprietorships and partnerships are taxed as personal income of the owner or owners.
Profits earned by corporations can stay in the company or be distributed to the shareholders in the form or salary, dividends, repayment of shareholder loans, capital dividends or repayment of capital.
The system, called integration, is designed so that the corporate tax a firm pays plus the personal tax paid on salary or dividends should total about the same as if the money were earned by a proprietor without a corporation. The tax advantage comes if you take little money out in salary or dividends and leave profits in the corporation to grow it.
“As a business owner one of the dilemmas is how do we derive our income, what is the best split?” said Yih. “One advantage a corporation does have is control of how that money is drawn out of the company, whereas a sole proprietorship doesn’t have that much flexibility. I can choose to take dividends one year, I can choose to take a salary, I can choose to take shareholder loans.”
How you withdraw money is important.
If you take a salary, it is earned income that creates RRSP contribution room, and the salary is deductible to the corporation. If you take dividends, the dividend tax credit reduces your taxes, but the dividends are considered investment rather than earned income and don’t create RRSP room, and the dividends are not deductible to the corporation.
One strategy is to pay yourself enough in salary or “bonus down” by taking a bonus before your year-end to reduce your corporate income to $300,000, the level at which the small business tax rate expires.
Generally $200,000 in annual revenue is suggested before incorporation.
Ray Turchansky is a freelance writer and income tax preparer.
Small Business Report 2005
© The Vancouver Sun 2005