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Fredericton Daily Gleaner ~ Capital Appreciation ~ Labour Day ~ September 4, 2006 - 17 Sep 2006 by TaxHelp
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Another Labour Day morning with quiet in the house. It’s the time of year that people get re-invigorated. Some kids head back to their local schools while others leave to attend the various colleges and universities. Some people look to the various circulars to see what classes are available or activities they can join. Still others decide to finally start that small business they’ve been thinking about. Once that decision has been made, one of the biggest initial determinations to make is in what legal form the enterprise should be.
Right away, many people presume that incorporating is the way to go. However, the primary reason to incorporate is to limit liability. Any time someone does business with a company that has an inc. or ltd. or some other variant in the name, he or she should realize that the firm is holding itself out to the public as having a maximum financial amount that it can be held accountable for. That number generally represents the total equity of the firm. As a result, any shareholder puts at risk only his investment and holds no personal liability.
So how do you determine if you should become incorporated? The question one needs to ask is “What’s the downside risk?” or “What’s the worst thing that can happen?” My buddy, Tim the painter, knows that acting as a sole proprietor gives him certain benefits. First, if he has any losses, they can be directly applied against any of his other income if he has a ‘real day job’. This is particularly advantageous in the first few years, since many people start out their business while continuing to work at other employment. These losses have the effect of lowering taxable income (and as a result raising refunds). So if Tim asks himself the risk question, the worse thing that could happen to him is that he might be called back to paint a room – hardly fiscally life threatening. On the other hand, if Tim was a painter of aircraft, and he applied the wrong type of paint, and obscene disaster struck, he would be ruined both emotionally and financially. One hardly has to find an example so dramatic though. Tim could decide that there is no risk since he’s a house painter. He hires a helper who drives the van and causes a serious accident. While automobile liability insurance may cover any awards, the court may determine an amount that exceeds the insurance coverage, again wiping him out. Even if there is no third party involvement, maybe Tim’s employee falls off the roof and sues him as a result of an unsafe work condition (in the event the employer neglected to obtain workers compensation). The shareholder of a business that is incorporated does not deal with these issues. While the business may be sued, the most that can be lost is the value of its assets. As a result, any investment the shareholder has made is at risk, but his or her other assets are not inclusive. That’s why sometimes it’s best to have multiple incorporations, each with a specific asset, so that if a charge is made against one, the others are not at risk.
Another benefit to incorporating is the lower tax rate applied to the net income. In Canada we have a reduced tax rate on companies with lower net incomes. In New Brunswick we have the lowest combined federal-provincial tax rate in Canada. The charge is about 15 per cent once the small business rate is factored in versus the general corporate rate of about 35 per cent. Someone whose business earns $125,000 after expenses pays a top-dollar tax rate of almost 47 per cent if it is on their personal return. As I suggested earlier, the corporation is taxed at 15 per cent, leaving more on the table to be paid out in the form of tax-attractive dividends. And then when it comes time to dispose of the business, the capital gains from any sale of a corporation like this are exempted from taxation to a lifetime maximum of $500,000.
So what’s the downside? First, there is a cost to incorporating. While federal incorporations sound impressive, the legal cost is greater when compared to a company which obtains a provincial charter. Then there are the on-going additional charges. Without a doubt there is more bookkeeping to be done, and a corporate tax return has to be filed (the T2), which also incurs another expense. Furthermore, many lenders will not lend directly to a new business without a guarantee from the principal, so in many cases bankruptcy captures both personal and business assets.
However, for many businesses that have been in operation for a few years, incorporating may be a timely option. And if the risk is great from the moment you hang out your shingle, you may want to begin with a limit to your liability by forming a corporation. At least it’s something to consider as you enjoy the day.
Roger Haineault is with Help 4 Taxes. He can be reached by email at roger@help4taxes.ca or by calling 1 (888) 450-1212. His column appears Mondays. |
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