Should I Incorporate My Business? | FPCBO 134
The Financial Planning Association of Canada | E134
Thinking about incorporating your small business in Canada? Hold on! This video breaks down why staying a sole proprietorship could save you thousands of dollars and even let you deduct your mortgage interest. We'll cover what a sole proprietorship is, its advantages and disadvantages, and reveal two tax planning strategies that are exclusive to sole proprietors. Discover how to deduct business losses and utilize the cashflow damming strategy to maximize your tax savings. Start smart and learn why sole proprietorship might be the right choice for you.
FPCBO 131 - Is Your Share Structure Making Your Business Sale Taxable?
https://youtu.be/hjLmFJAV-CU
Full Transcript
FPCBO 134 - Should I Incorporate My Business?
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[00:00:00] If you're starting a small business in Canada, you might think that incorporating is your smartest move, but delaying and staying a sole proprietorship could save you thousands of dollars for years and even let you deduct your mortgage interest. In this video, I'm gonna break down what a sole proprietorship is, discuss its pros and cons, and highlight two unique tax planning strategies.
Exclusive to sole proprietorships, a sole proprietorship is Canada's simplest form of business ownership, where you are the business basically, legally and financially. One entity. You don't file a separate tax return for the business. Instead, all of your business activities are reported on your personal tax return using something called a Form T 2125.
This schedule details your business income and expenses with net income added directly to your personal income and taxed at your personal income tax rates. Essentially from both a tax and liability perspective, you and your business are inseparable. A quick note here, partnerships in Canada function similar with multiple owners.
Instead of one, they can [00:01:00] divide income and expenses, each reporting their own share on their own personal tax returns. However, for simplicity's sake, today I'll focus on sole proprietorships. Even though this does apply to partnerships. In contrast, the corporation is a distinct legal entity with separate financial records, its own tax return, and individual tax rates while you own the shares of the corporation.
It owns the income, the assets, and the liabilities. Let's quickly outline the advantages and disadvantages of sole proprietorships. The pros include that its easy and inexpensive to set up. There's minimal administrative requirements. And lastly, tax reporting is really simple. The cons include that there's no legal separation between you and the business, which means that you bear unlimited personal liability for the business's actions.
Though you can't protect yourself of various forms of insurance, all income is taxed at higher personal tax rates without the benefit of the deferral of corporate tax rates. But if you're in a position where you're taking out all the income from the corp anyway, then there is no difference to you. Your business will be harder to sell as a business that isn't a separate legal [00:02:00] entity is a little bit harder to put a wrapper on.
Some vendors will require you to incorporate in order to deal with them. And lastly, you will not have access to the lifetime capital gains exception upon sale. I covered this benefit in another video that I'll link in the notes. Now, from a tax perspective, incorporating often seems attractive due to lower corporate tax rates of between 12 to 13% on the first half a million dollars of income, depending on what province you're in.
Versus the personal tax rates, which can top out at over 50%. However, incorporating eliminates two valuable tax strategies, exclusive solely to sole proprietorships. First sole proprietors can deduct business losses directly from personal income. This strategy is especially beneficial for entrepreneurs who are running a side business alongside their main job.
For example, your day job may pay a hundred thousand dollars and your side business may lose 20,000, so that reduces your taxable income to 80,000 significantly lowering your personal tax bill. Conversely, a corporation's losses stay within the corporation and can only offset corporate income in that year or other years.
The second [00:03:00] key advantage is a strategy known as cashflow damning. The simplest way to understand this is as follows, sole proprietors aren't required to use business income to directly pay for their business expenses. This flexibility lets you strategically manage your debt. For significant tax savings.
A little confused. I get why, but let me explain how it works. In Canada, mortgage interest is not tax deductible. However, interest on loans taken out for investments or business purposes are deductible, including mortgages and home equity lines of credit taken out that in order to actually run a business.
So let's imagine you're a sole proprietorship earning $200,000 annually with $125,000 in expenses. You also have a $500,000 mortgage and a HELOC with nothing outstanding on it. Instead of using the $75,000 net business income to pay down your mortgage, you can apply the full $200,000 to pay down the mortgage down to $300,000.
You can then fund your expenses with the HELOC to the tune of $125,000. You'll still owe [00:04:00] $425,000 at the end of the year, but now $125,000 of that debt will have its interest be tax deductible because it was related to business expenses. Repeat this approach annually and this approach could shift all of your mortgage debt to deductible debt.
For example, a $500,000 5% interest mortgage is gonna cost roughly about $24,676 in yearly non-deductible interest. By converting that debt into deductible interest, the tax savings could be anywhere between $5,900 to over $13,000 annually, depending on your marginal tax bracket and province. There are some key considerations, including maintaining clear documentation to link the loans to the business expenses, using dedicated borrowing accounts to make tracking easier.
Understanding the potential limits of prepayments on your mortgage and any penalties associated with it, and the fact that HELOC rates are variable. Now, while the strategy benefits higher income earners significantly, incorporation might be more advantageous as your business grows. In short, especially early on, operating is a sole proprietor, [00:05:00] can be a simpler and actually more tax efficient way to run your business.
You can always incorporate later, but initially don't overlook these opportunities. Thanks, and I'll see you again next time.