Incorporation vs Proprietorship
When establishing a new business, one of the first decisions is whether it should be a proprietorship or an incorporated company. Many people incorporate right away because they have heard that this is more beneficial from a tax point of view, and because it protects the business owner from creditors in the event the business fails. Each situation is different, but it is often practical to start off as a proprietorship and then convert to an incorporated company once the business is off the ground and the owner has a better sense of how it is progressing.
In an incorporated company, business profits are taxed at a much lower rate than in the proprietorship. However, if the owner withdraws all the profits for his own compensation, the tax advantage is lost because all the withdrawals are taxed at personal tax rates. The tax advantage arises when the owner makes sufficient profit within the incorporated company so that only a portion of the profits are withdrawn as compensation, with the balance remaining in the company to be taxed at the lower corporate rates. There is a much higher tax rate in the corporation when profits exceed a certain threshold, but this is normally dealt with by bonusing down the profits below the threshold. This creates additional personal tax to the business owner, but saves the company from the much higher tax corporate tax rate.
There is a particular tax advantage to incorporating when the business owner has virtually no other income apart from the business income. In such a case, the owner can withdraw his business compensation in the form of dividends rather than salary, which would be taxed on his personal tax return at a very low rate. This would not be the case if he also took compensation in the form of salary or had other types of income outside the business, but in this specific situation, it is very beneficial from a tax point of view to set up compensation in this way.
If the company is a “small business corporation” and meets various other criteria, the capital gain which arises upon sale of the business is protected from tax to the extent of $750,000 (in 2010), which is an additional benefit of incorporation. However, if the company has investments exceeding 10% of the assets of the corporation, this can disqualify the company from receiving the capital gains exemption.
If the business is incorporated and has scientific research and development activities, the company will receive a higher investment tax credit than could be achieved in an unincorporated business. Please contact Simkover and Associates at 905-943-4046 if you need further accounting services or advice in relation to this topic.
Please contact us at 905-943-4046 if you need further assistance or accounting services in the coming months. Click here for additional contact information
Tip of The Week | Simkover and Associates