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When should you incorporate your small business?

It depends on how much money you need to live on (to pay your rent or mortgage, buy food, run your car, etc.).

You want as much money as possible. Right?Screen Shot 2019-06-06 at 1.32.06 PM

But first, what does it mean to incorporate a business?

The actual running of your business won’t change. But the way your business is taxed will change. Incorporating your business means there are now rules for how you can get your money. You can’t just take $10 out of the cash register and go buy lunch.

Being incorporated means your business is now a separate entity for tax purposes. Any money left in the corporation is taxed. Any money you take out of the corporation is taxed.

In order to take money out of the corporation, you only have two choices – pay yourself a salary and/or pay yourself a dividend. Let’s look at examples to see how this works.You live in Nova Scotia, own your own business and earn $150,000 a year. The business is not incorporated. The taxes paid would be about $50,240*.

To lower your taxes, you can put money in a registered retirement savings plan (RRSP). If you put the most amount allowed by the tax rules, you would only pay $38,665 in taxes. See our blog, Should you invest in an RRSP or a TFSA? for discussion of investing in a RRSP vs tax free savings account (TFSA).

Now, you incorporate your business. Again, it is in Nova Scotia. The $150,000 is now made inside the corporation.

As stated before, you can take money out of the corporation by paying yourself a salary and or paying yourself a dividend. Each way causes a different tax impact. Let’s look at this further.

Scenario 1: In this situation, you take all the money out ($150,000) as a salary. There is no tax for the corporation to pay because there is no money left in it. You would pay the same amount of tax ($50,240) as you would when your business was not incorporated. 

Scenario 2: Instead of a salary, you take the money ($150,000) in dividends. This would result in $0 tax in the corporation, because there isn’t any money left inside. You would pay about $40,091 in taxes on your personal tax return. This difference is because of the way dividends are taxed compared to salaries.

Scenario 3: Let’s say you want some of each. You take $100,000 in salary and $50,000 in dividends. Again, no tax is paid by the corporation. You would pay roughly $46,857 in taxes personally.

You can see from the 3 scenarios that taking all the money out as a dividend gives you the lowest taxes. So, already, you save money from incorporating by taking it out in different forms.

What if you decide to leave some of the money in the corporation rather than take it all out?

This would be a good idea. Your business can grow from the money left inside the corporation.

Using the same example as above, let’s leave $50,000 in the corporation and only take out $100,000. The same scenarios will be used as above.

Scenario 1: In this situation, you take the money ($100,000) out by paying yourself a salary. You would personally pay about $28,325 in tax on the $100,000 you took out. Since there is $50,000 still inside the corporation, there is income tax charged on it. The tax for the corporation would be about $6,500. So, adding both types of tax together would total $34,825.

Scenario 2: Here, you take the money ($100,000) in the form of dividends. The corporation would pay the same amount of income tax on the $50,000 left inside ($6,500). The tax on the $100,000 in dividends would be about $20,389, for a total tax of $26,889.

Scenario 3: If you want some of each, you can take $66,667 in salary and $33,333 in dividends (to keep the same split as before). The corporate tax is still $6,500. The tax on you, personally, is about $25,679. The total of both the corporate and personal tax paid is $32,179. 

Let’s summarize and put all these numbers in a table:

 

table one -- incorporating

 

You can see the option to take all money from the corporation in dividends in both situations, provides the lowest tax amount. However, there are some things that you may want to think about before making this decision.

a.

Taking all the money out in dividends does not allow you to have an RRSP. So, you are actually paying more in taxes than if you didn’t incorporate.

b.

You will likely need an accountant to prepare the corporate tax return. It isn’t the same as your personal one.

c.

You will likely need an accountant to prepare the tax slips (T4 for salary and T5 for dividends). There are also forms that need to be filed.

d.

There is an initial cost of incorporating. If you are a do-it-yourself type of person, you may be able to use the online approach (about $250). If you need help or your business is a little more complicated, you will need a lawyer (about $2,800).

e.

If you want to take some funds in the form of a salary, so you can make RRSP payments, you need to decide the best amount. 


If you are groaning now because I have only given you the costs, hang on, there are some non-cost reasons to incorporate.

  • An incorporated business tends to have more credibility than an unincorporated one. (This is subjective and may depend on the type of business as well.)
  • There is some protection from being sued if you are incorporated. Generally, a lawsuit against your company would only have access to the corporate assets. So, your personal belongings would be safe.
  • You may have losses in the first few years if you are just starting out. The losses stay in the corporation until you are making money. The Canadian tax people tend to frown on losses in an unincorporated business. (See Blog # Hobby Business BLOG on this – response to article)
  • You can actually pay yourself a salary from an incorporated business. You can’t do this if you aren’t incorporated. 

Want help making this type of decision? Download the spreadsheet.

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*Please note: the tax calculations are based on the tax rates in effect at the date of this blog, and the taxpayer being a resident in Nova Scotia.

 


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