The main advantages of incorporation versus sole proprietorship are:
- Incorporation provides “limited liability”, whereas sole proprietorship does not. A corporation’s net assets are separate and distinct from the net assets of the shareholders of the corporation. In most cases, the shareholders’ personal assets will not be at risk if the corporation alone is sued.
- Incorporation, as opposed to sole proprietorship, provides much more flexibility to legally minimize overall income taxes. The overall tax reduction with the use of a corporation can be substantial. Every situation is unique and should be reviewed with a professional accountant.
- As a sole-proprietorship, you are limited to setting December 31st as the year end of the business. An incorporated entity can set a year end at any time during the year. This provides the flexibility to minimize overall income taxes, by allocating corporate income, which has a year end that straddles December 31st, to two tax years of an individual shareholder, and his family members, who file their tax returns on a calendar year basis. This provides the ability to keep overall income in the lower tax brackets and thus pay less tax on the same income.
- The main tax advantage gained with incorporation is access to acceptable “income splitting” opportunities. The corporation is a separate and distinct legal entity that files its own corporate tax return, in which income can be split off and be subject to a lower corporate tax rate. Generally speaking, the current overall corporate tax rate is 16.5% (for corporations that are resident in Ontario) for contractors earning their income inside a corporation. If not incorporated, an individual or sole proprietor, on the same income, could be paying a tax rate of approximately 46% on portions of the same income being earned. As you can see there is an approximate 30% tax rate differential being paid (46% compared to 16.5%). In addition, acceptable income splitting can be accomplished with other family members when a corporation is utilized, as the flexibility to income split via dividends to these family members is available and thus applied to their lower personal tax brackets.
One must be careful when “income splitting” to other family members via salary or “fees paid”. The question to ask oneself is, “what would l pay an arm’s length party to do this work they are doing?” In most cases, this would involve minimal amounts of income. With a sole-proprietorship, one is limited to income splitting to other family members via “salary or fees paid” to that other family member(s). With a corporation one can also legally and acceptably income split with other family members via “dividends”, which is not based upon a “value for service rendered” concept; rather the payment of dividends, and thus access to income splitting, is based upon share ownership in the corporation. Therefore, the corporate model provides access to income-split much larger amounts than you would be able to income split via a sole proprietorship.
- A corporation provides the flexibility to opt out of the CPP defined benefit pension plan; a sole proprietorship cannot opt out of the CPP plan. The current annual maximum CPP contribution is in excess of $4,000 per year.
The main disadvantage to incorporating over sole proprietorship is the cost for professional services for incorporation. Up-front fees to incorporate can range from a few hundred dollars if the contractor can incorporate himself/herself online, to upwards of $1,500 if using a lawyer to incorporate, perhaps because multiple classes of shares are required.
You will also need an accountant to prepare your initial financial plan and to carry out the plan when filing your annual corporate tax returns. Plan preparation, which is a one-time up-front fee, can cost as little as a few hundred dollars or as much as $1,000 and annual filing fees by an accountant can also range from a few hundred dollars to a few thousand. Typically, however the income tax savings accomplished through incorporation far exceeds the professional fees incurred.
In general, if you are committed to a career as an independent consultant, CORADIX recommends incorporation, but you should seek professional accounting and legal advice specific to your circumstances.