What You Should Know About Incorporating
Updated: Jan 17, 2021
Thinking of Incorporating things to keep in mind:
When converting from a sole prop to a corporation some things to keep in mind:
There are specific rollover provisions contained in Section 85 of the Income Tax Act that allow for you to transfer your sole proprietorship to a corporation on a tax-free basis. Shares of the corporation must be received on the transfer. The rollover is undertaken by filing Form T2057. Although this is a standard transfer provision, it is fraught with landmines.
The combined legal and accounting fees to undertake this transaction can range from $5,000 to $10,000 depending upon the complexity of the transfer. As such, many people decide to forgo this step, especially when they consider their main proprietorship asset to be personal goodwill (you are the business and without you, it is worthless) as opposed to business goodwill (the portion of the business value that cannot be attributed to business assets such as inventory and equipment. i.e. The value of your business name, customer list, intellectual property etc). However, if you ignore filing Form T2057, you do so at your own risk.
This is because when you transfer your assets and goodwill from your proprietorship to a corporation, you are deemed to have sold or disposed of these assets at their fair market value. In order to avoid this deemed sale and to ensure you do not create any income or capital gains upon the transfer of these assets, I always suggest filing the tax-free rollover under Section 85.
As noted above, I have had clients argue they have no business goodwill and that all their goodwill is personal in nature. While in some cases there may be some validity to this argument, I think it is penny wise and pound foolish to take the risk that the CRA will deem a large gain on the transfer of your proprietorship goodwill when you can just make the election and eliminate that concern.
COST AND ADMINISTRATIVE CONSIDERATIONS
The cost of maintaining an incorporated company is far more expensive than operating a proprietorship. You must file financial statements with the CRA and the corporate income tax returns are complicated. You require annual legal resolutions and the administration is far more costly.
Thus, I would not recommend the use of a corporation (subject to the other factors such as creditor proofing and the capital gains exemption discussed above) unless you could leave approximately $50,000 at minimum, but more like $75,000 of taxable income in the corporation after any salary you require.
Proprietors sometimes have difficulty separating their corporate funds from their personal funds as they are used to taking draws and simply paying tax on their business income. The corporate structure is more formal and personal drawings must be paid in the form of salary with income tax withheld and/or dividends. Both require filing of government forms (T4/T5).
The income tax benefits of a corporation can be significant.
However, the transfer of a proprietorship to a corporation is very complex, especially when introducing family members as shareholders. It is thus vital that you engage an accountant and a lawyer to explain all the income tax issues to you before undertaking the transfer.