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Sole proprietor or incorporate? A side-by-side for small businesses
Incorporating can lower the tax on profits you leave in the business. It also adds costs, paperwork and a second tax return. Here is how the two structures compare, and the question that usually decides it.
Small business At some point most freelancers and small business owners hear that they should incorporate to save tax. Sometimes that is right. Often it is premature. The honest answer depends less on how much your business earns than on how much of it you need to live on.
This is general information. Incorporation affects your taxes, liability and paperwork for years, so speak to an accountant who can look at your numbers before you decide.
The two structures at a glance
| Sole proprietorship | Corporation | |
|---|---|---|
| Setting up | Simple; register a business name if you use one | Incorporate federally or provincially, with filing fees |
| How profit is taxed | On your personal return, at your marginal rate | Corporate tax first; personal tax when you pay yourself |
| Tax on profit left in the business | No difference; all profit is taxed personally | Can be much lower, using the small business deduction |
| Liability | Personal assets exposed to business debts | Generally limited to the corporation, with exceptions |
| Tax returns | One personal return with business income | A corporate return plus your personal return |
| Ongoing costs | Low | Higher: accounting, annual filings, separate banking |
Where the tax saving comes from
A Canadian-controlled private corporation can usually claim the small business deduction on its first $500,000 of active business income, which brings the federal corporate rate down to 9 per cent. Provinces add their own, also reduced, small business rate. Combined, that is far lower than the personal marginal rate most owners pay at higher incomes. We explain the deduction in detail in the small business deduction, explained.
The catch is that the lower rate applies to profit while it stays in the corporation. When you take it out, as salary or dividends, you pay personal tax on it. Canada’s tax system is designed so that, over the whole journey, the total tax is broadly similar either way. The real benefit is deferral: tax on money you leave in the company is postponed until you take it out.
Incorporating does not shrink the tax on money you spend. It postpones the tax on money you do not.
A worked example
Take an illustrative consultant whose business earns $90,000 a year in profit and who needs $85,000 of it to cover rent, living costs and savings. Almost all of the profit comes out every year, so almost all of it is taxed personally either way, and the corporation adds accounting costs without much deferral. Staying a sole proprietor is probably simpler.
Now take the same business at $180,000 in profit, with the owner still living on $85,000. Roughly $95,000 a year could stay in the corporation, taxed at the lower small business rate until it is withdrawn. That deferral, invested over several years, can be worth far more than the extra accounting fees.
Liability is less of a shield than it sounds
Incorporating generally separates business debts from personal assets, but lenders and landlords often ask small business owners for a personal guarantee, and professional negligence can still follow you personally. Insurance is often the better protection.
Other things that change
Pros
- Tax deferral on profit left in the business
- Flexibility in paying yourself salary, dividends or a mix
- A separate legal entity that can make the business easier to sell or bring partners into
Cons
- Set-up costs and annual filing fees
- Higher accounting fees for a corporate return and financial statements
- Money in the corporation is not yours personally until you pay it out, and taxed then
- Salary choices affect CPP contributions and RRSP room
If you run your business from a rented apartment, the home office rules apply differently to a corporation than to a sole proprietor; our guides to claiming home office expenses when you rent and running a business from a rented apartment cover the basics. For the steps to set up either structure, see starting a business on Canada.ca; the CRA’s corporations pages explain the tax side.
End of the story · 6 min
WAbout the writer
Daniel Tremblay
Small business writer
Daniel kept the books for dozens of sole proprietors and small corporations before turning to writing. He explains tax deductions, credits and government programs for small business owners, and always says when it is time to call an accountant. He works from the Canada Revenue Agency's own guides and forms, and his pieces tend to end with a short list of what to keep on file, because most small business tax problems start with a missing receipt rather than a wrong number.
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