Anyone can start a sole proprietor business. You don’t need permission to do so (though you may need a licence depending on the business); you just do it. Give yourself a name, generate interest in your products or services and go. Any business income or loss is reported directly on your personal taxes.
It’s a simple way to run a small business and a simple way to report business income. But as success takes over and the months and years go by, the realities of your legal and tax situations can change and you need to consider whether it’s appropriate to incorporate your business.
There are financial and legal benefits to incorporating but there are also a few potential drawbacks so it’s important to assess what makes the most business sense before making the decision. And you will also need professional advice on selecting the right time to make this switch, to coincide with tax years, corporate reporting, and government deadlines.
Let’s look at the benefits of incorporation first. Should you incorporate, your business becomes a separate legal entity, so creditors or legal action goes against your corporation and its assets, not you and your personal assets. Incorporation also allows you to choose the most tax-efficient way to pay yourself, such as dividends, salary, bonuses or a combination of all three. As such, should you not need all of your business earnings for your personal income, you can leave some in the business to defer your personal taxes on withdrawals.
But incorporating costs money. You can save some money by doing it yourself, but it’s advisable to have help from a lawyer and an accountant. There’s a lot of paperwork that needs to be filed with the government, not only to incorporate but on an annual basis (the business, for example, now needs to file a separate tax return). And should your incorporated business incur losses, they can’t be personally claimed, meaning you can only ‘write off’ the amount you initially invested, not the accumulated negative earnings.
The right time to incorporate for one small business may not be the right time for another. From a tax perspective, there is no magic number that states, “this is when you must incorporate.” Basically, you need to constantly re-evaluate your business and revisit the question often.