Understanding the Pros & Cons of Different Business Structures so You Know When to Incorporate

I was up on the stage to share some tax tips with over 660 real estate investors.

I have never done a presentation to 660 people before. Getting up on the stage surely makes me nervous.

My goal was to share tax traps that can be avoided so everyone can stay out of trouble. Hopefully everybody got to learn a thing or two.

In my corporate life, I never really had to do presentations. My boss at Deloitte at the time sent me to the Dale Carnegie course to learn how to effectively communicate with people and how to do a presentation.

I still remember how nerve wrecking it was to speak in front of a crowd the very first time.

My heart was pounding, my palms were sweating, my throat was drying up. Then I got all self-conscious about my accent.

And I forgot all about what I learned during the course. It’s rare that accountants are required to do presentations to a big crowd in a corporate setting.

It was not until I started my own accounting practice that I started doing presentations more often.

Today, if I do a presentation about accounting and tax, I wouldn’t necessarily call it easy but the presentation goes a lot smoother than it did years ago, even compared to when I was at the Dale Carnegie course.

It’s all about practice and training. Everyone’s gotta start somewhere! A friend of mine has been looking at private label supplement manufacturers for his new business, and I’m giving him the exact same advice. There are lots of things to think about when you’re starting a new venture but just be confident and you’ll go far… trust me!

It’s no different than owning a piece of real estate. Let’s get down to the basics and discuss the different ownership structures of your business/real estate and their pros and cons.

Sole proprietorship

Sole proprietorship is the simplest form of ownership. You can simply start up a business or own a property without any registrations (you may still need to register your business depending on what you are doing, for instance if you’re a small Landscaping business then you’ll need to be registered due to certain Landscaping taxes).

Income from your business or property are then recorded in your personal tax returns. You are eligible to deduct reasonable expenses that you incur for earning the income.

If you earn business income, you’re then required to contribute to both employer and employee’s portion of Canada Pension Plan. This is often computed as part of your personal tax return.

Your tax return for being self-employed is due June 15, but the tax payable is due April 30.

Pros

• Cheapest form of ownership to setup and its simple to setup
• Any losses generated from either your business or properties can be used to offset against other income
• It’s also easier to keep track of all your income and expenses. You are not required to have a business bank accounts and can simply take money out from the business any time you want.

Cons

• Much higher tax rate if you are making big money. Highest tax rates in Ontario is 54%. But the first $500K for Canadian Controlled Private Corporation (CCPC) is only subject to 15% tax rate.
• Limited ability to split income with your spouse.
• Unlimited liability. If the business get sued, the sole proprietor is personally liable for all the liabilities. Creditors can even jeopardize your own principal residence.
• No continuity of business. If sole proprietor passes away.

Partnership

When more than one person operates and owns a business together, you form a partnership.

Like sole proprietorship, each partner is required to report his share of business or property income individually in his personal tax return.

It’s often simple to operate.

Like sole proprietorship, each partner’s tax return is due June 15 but the tax liability is due April 30 of the subsequent year. Paying things like tax is often at the back of the minds of business owners. Another pain to running a business is sorting out payroll.

Pros

• Similar to Sole Proprietorship, it’s the simplest and cheapest form to setup.
• It’s also relatively simple to keep track of cash flow, income and expenses. You can take out the cash from the business without much tax concerns.
• If you own the business with your spouse, you can split income with him/her.
• Any losses generated from the partnership can also be offset against other sources of income to lower your personal tax liability.

Cons

• Once ownership percentage is established, there’s no flexibility in terms of how to change it subsequently.
• No continuity. Partnership doesn’t exist anymore if one partner passes away.
• Unlimited liability – All partners are jointly liable for the action of any partner in the business. If one partner makes a bad business decision, every partner’s personal assets can be at risk.
• Like sole proprietorship, if you earn significant income in the partnership, you can be subject to a much higher rate than earning income in a corporation.

Corporation

Corporation is considered a separate legal entity in the eyes of law. This means that you need to maintain proper record of the corporation whenever you put money in and take money out of it. You will also need to register your corporation

Pros

• Limited liability protection: Corporation is considered a separate legal entity. It can be sued on its own.
• With proper setup, you can split income with your lower income spouse and adult family members.
• You can also split income by paying your family based on the services they provide to the corporation. The compensation must be reasonable for the services they provide.
• Enjoy lower tax rate if you are earning active business income lower than $500,000 inside a CCPC. Tax rate is only 15% and you are able to use higher after tax dollars for investment.
• If you do decide to sell the business in the future, you can potentially sell the shares and enjoy a capital gain exemption for around $800,000, provided that the business qualifies as small business corporation.

Cons

• Cost to setup the corporation is relatively high. Legal fees to set it up can range from $1,500 to $2,500.
• Higher maintenance cost: Generally speaking, the cost of filing a corporation tax return and preparing the financial statements are more expensive than that of personal tax return. Business bank account charges are often higher than personal account bank fees.
• Separate banks and records must be established. Money withdrawn by the owners from the business must be properly accounted for. More often than not, there’s tax implication every time money is being withdrawn.
• If you generate a loss inside the corporation, you can carry the losses forward for 20 years but you cannot use it to offset other income earned in the shareholders’ personal tax return.

When should you incorporate to own your business?

This is often the million dollar question for all real estate investors, business owners and realtors.

For real estate investors, although you cannot enjoy the 15% active business rate (please refer to my blog post regarding how rental income is taxed inside a corporation), you can still use the corporation to split income with your lower family members and liability protection.

For small business owners, incorporation provides the liability protection that you would not otherwise get and significant tax advantage. If you don’t need all your cash flow from your business, it is often a great way to save and invest within the corporate structure.

For realtors, you may think that incorporation isn’t even an option for you. But the reality is that you can bypass the system and setup a corporation by operating a mini brokerage. You too can also enjoy the significant tax advantage within a CCPC.

Truth is, incorporation is a personal choice and it should be determined based on your personal situation. Consult a professional to make an informed decision.

Until next time, happy Canadian Real Estate Investing.

Cherry Chan, CPA, CA

Your Real Estate Accountant