Sole proprietorship vs. incorporation

December 9, 2014

Sole Proprietorship vs. Incorporation

Most entrepreneurs face the question of whether or not they should incorporate relatively early in the life of their business. Let us take a look at the main advantages and disadvantages between the sole proprietor and incorporated structure.

Proprietorship

A sole proprietorship is an individual who is operating a business without any formal corporation. In this scenario the profit of the business is accounted for and taxed personally and added to the individual’s personal tax return. A sole proprietorship is in line with personal taxation year-ends and follows a calendar year.

Main advantages

  • Ease of setup and operations resulting in lower administrative costs – There is no need for shareholder meetings and formal corporation filings. Setup is also very easy, requiring minimal paperwork.
  • Ease of control – The control of the business is in the hands of the individual. This may not always be the case in an incorporated organization when considering different levels of shareholders and board members.
  • Use of losses to offset personal income – Any losses incurred by the proprietorship can be used to reduce any other income earned by the individual.

Main disadvantages

  • Unlimited liability – This is the most discussed disadvantage of proprietorships that exposes the individual and all of his or her personal assets to risk if the business is sued.
  • Higher tax rates – If the business is extremely successful it can be subject to the highest personal tax bracket, which can be much higher than tax rates for a corporation.

Corporation

A corporation is a separate legal entity and is usually created by filing the appropriate paperwork with federal or provincial levels of government in Canada. Corporations are controlled by shareholders who are also the owners of the corporation. Corporations file tax returns separately from the owners and are able to set their own year-end.

Main advantages

  • Limited liability – Conversely to how unlimited liability is the proprietorship’s most commonly discussed disadvantage, limited liability is the main benefit of incorporating. The liability of the shareholders is limited to the amount they invested into the company. However, if the corporation is sued, the assets of the corporation are at risk.
  • Ability to defer tax and lower tax brackets – In Canada, a Canadian Controlled Private Corporation (CCPC) is subject to a lower tax rate on the first $500,000 (as of 2014) of net income earned in active business. By using a non-calendar year-end and leaving earnings in a corporation, taxes can be deferred at the lower corporate tax rate in comparison to paying at the usually higher personal tax rate.
  • Capital Gains Deduction – If you get to the stage where you are looking to sell your business (or part of it), the incorporated structure has another advantage. For qualifying small business corporations, there is a $750,000 capital gain deduction on the sale of shares.

Main disadvantages

  • Increased administrative and setup costs – Since a corporation is a separate legal entity, it requires a separate tax return to be prepared and the costs of incorporating and setting up a business are much more costly than a proprietorship.
  • Complicated structure – Setting up your corporation and determining the ownership structure through different levels of shares can be very complex. A basic share structure of one type of common shares might lead to complications down the road when bringing on additional shareholders, investors and estate planning. Plan for these scenarios in the beginning to avoid added costs later on.
  • Personal guarantee – when a shareholder gives a personal guarantee on behalf of the corporation to obtain financing, the individual’s assets will be at risk if the corporation defaults on financing.

Generally speaking, it is more and more beneficial to have an incorporated structure as opposed to a sole proprietorship when your organization makes more income. It is strongly suggested to gain further council on making the decision on what type of structure best fits your needs and organization, as everyone’s case is unique.

 Image credit: by Barenboime, via flickr.com.

Author

Nav Dhaliwal

Nav Dhaliwal is a Chartered Accountant based in Toronto, Ontario with several years of experience and a partner at ND LLP. Believing in doing accounting differently, he integrates the accounting world with technology by providing virtual solutions to organizations of every size.