When Should I Incorporate My Startup Or Small Business?

When is time to incorporate your Startup or Small Business?   

We've all heard the pros and cons of incorporating. But is there a better time to go ahead and incorporate?  Or is today as good a day as any?    

The answer: it depends.    

I know that's probably not the answer you were looking for, but in actuality, there are a few variables that can swing your decision in either direction.    

Legal Risk:

As you probably already know, an incorporated company is a separate legal entity. This means that the corporation is liable and responsible for their own actions and is independent from you (in most cases).  If your business is in an industry or space where there is little legal risk, you may not be in a rush to incorporate if the other options below don't heavily favour incorporation either.    

But, if your corporation is in a field where legal liability is high, you may want to incorporate, irregardless of the variables below, because liability issues can sink a growing company fast.  In essence, if an issue occurs and you are not incorporated - you can be sued and your personal assets are at risk (your home, your personal bank accounts, etc.).  If an issue occurs and you are incorporated - the corporation is sued, and in my cases - it stops there. Your corporate assets are at risk, this is true, but your personal assets are shielded.    

Disclaimer: This is ideally the case, but there are times when the corporation cannot shield your personal assets, such as when fraud or negligence is involved. It would be prudent to discuss this with a lawyer first.    

Losses:

Some background first: An incorporated company is a separate legal entity and has to to file their own corporate tax return. An unincorporated company (sole proprieroship/self-employed) is an extension of you, and as such, the income and expenses of this company are recorded on your own personal tax return.     In the initial startup phase, many companies incur losses at first (i.e. Expenses are higher than income).

If you are unincorporated, those losses can be used to reduce other types of income on your personal tax return. In a corporation, those losses are trapped in the corporation and can only reduce income from within the corporation. So, if the corporation is not producing income, those expenses are not saving you any money at first. The good thing is that these losses can be  carried forward to reduce income in subsequent years.    

Decide whether you need these losses to reduce your personal taxes or if you're better off incorporating now and utilizing these losses in future years when your startup starts to earn income.    

Income/cashflow/taxes:  

One of the driving factors of incorporation are tax savings. Corporations in Canada pay a much lower tax rate than individuals would (in many cases). People run to incorporate for this reason alone, without understanding the exact idea behind it.     In simple terms, a corporation in Ontario is taxed at 15.5%. If your net income is $100,000, your corporation would owe tax of $15,500.  Personally, it would be much more than that, close to double.     Incorporating looks like a clear winner here.    

But wait.    

If you, personally (as shareholder of the corporation), need that money to live on, and you withdraw the funds from the corporation to live (pay bills, travel, etc.), then that money coming to you is considered income and is taxed at your personal rate (depending on how much you withdraw).  If you were to withdraw everything, the combination of taxes paid at the corporate level and at your personal level will almost equate to you earning that income personally.  But, if you were to leave/retain some or all of that money in the corporation, then the corporation is paying it's 15.5% rate and nothing more.  So, you really need to assess your cash requirements personally and compare that to the income you are/may be making in the corporation to truly understand whether it's time to incorporate for tax reasons.    

Income Splitting: 

Depending on your corporate structure and stage in life, corporations provide owners with the ability to split income with family members, which helps reduce the overall tax burden.  This strategy can get complex, but with the right advice and execution, there is money to be saved.    

This is by no means an exhaustive list. There are even more options to consider too, such as: If certain assets are involved (like intellectual property), if you are thinking of issuing stock options, taking advantage of capital gains exemptions, if you are seeking angel or venture capital funding and more.