A small business usually starts out as a sole proprietorship, owned and operated by the founder personally and reporting business income on their annual personal tax return.
But as the business grows, the question of incorporation will always arise, and there are several factors to consider when this happens.
The most important single factor, in my opinion, is the tax savings that can be achieved through the corporate structure. Income earned in the corporation is taxed at a relatively low rate (20%ish) for small businesses (in Canada at least) and is then taxed when it is paid to shareholders as dividends.
Unincorporated business income is taxed at the earner’s highest marginal rate, which, in Canada, is 46%(ish).
The conclusion is that income that will be reinvested in the business (and thus, not paid out as dividends) will be taxed at a lower rate and allow the business to grow much faster than if it remained unincorporated.
If losses are expected, the owner is better off unincorporated, because those losses will flow through to his/her personal return and can be used to offset other sources of income. Losses in a corporation can only be used against income earned in that corporation.
- Separating business and personal income
- Controlling the timing of business (dividend) income
- Limited liability of the corporation