New Business – Sole Proprietor or Corporation

June 22, 2023

See the Professional Disclaimer should you wish to rely on the information in this article.

Updated for tax rate changes in 2023.

  • In this case study we will show the following:
    • The consequences of operating a business as a sole proprietor.
    • The consequences of operating a business through a corporation.
    • Recommendations as to the best mode of operating a new business in Canada.
    • Provide miscellaneous considerations.

Background

  • 43 Year old individual entrepreneur, Ms. Jones, wants to start a marketing consulting business after spending 20 years in employment with marketing firms in various capacities (other than administrative or financial)
  • Estimates of first year revenue: $235,000 in billings
  • Estimates of first year costs / expenses: $30,000 broken down as follows:
    • $2,000 telephone and internet
    • $3,500 stationery
    • $3,500 advertising including Google AdWords
    • $1,800 bookkeeping and tax
    • $12,000 for a small office
    • $7,200 for travel, local and national
  • Estimates of capital expenditures: $5,000 for a new laptop and monitor to be used solely in the business.
  • There will be no employees for the first two years.
  • Ms. Jones estimates that she will need funds for personal living expenses starting in the third year and will fund her first two years of business out of her savings.

Options for Mode of Operating the New Business

In Canada, Ms. Jones has two primary options for mode of operating her business:

  • Sole proprietorship (do nothing); or
  • Corporation (incorporate a corporation in a province or federally).

If Ms. Jones had partners or investors in her new business, she could also consider a partnership as another mode of operating her business.   To keep this article focused on comparing sole proprietorship versus incorporation, we will eschew discussion of partnership as a mode of operation.

Sole Proprietorship

To start a business as a sole proprietorship, Ms. Jones essentially needs to do nothing special to start her business, when compared to incorporating.  Of course, Ms. Jones cannot ignore any requirements of her professional body like registration or the arrangement of liability insurance or GST/HST registration with the CRA, but those requirements exist for the incorporating choice too.

Most entrepreneurs or self-employed individuals like to operate their business under a business name.  Ms. Jones would also like to operate under a business name, and she registers that business name with the Ontario government.  She can now open a bank account and receipt payments under that name.

Note that Ms. Jones is personally liable for any contentious or negligent acts conducted in her business.  That would not be the situation if her business was operated through a corporation. 

If Ms. Jones wants to find investors to expand her business, normally they will not invest in a non-incorporated business unless it is a personal loan to Ms. Jones which is not invested funds but debt and personal debt for Ms. Jones.  This is a major benefit of incorporating versus operating as a sole proprietor.  However, Ms. Jones will have a greater ability to maintain control over her business since there are no other ownership interests involved.

If Ms. Jones wants to sell her business in the future, she will need to sell the parts (assets) such as brand name, business name, goodwill and any physical assets like computers and furniture.   You should note that this can result in capital gains to Ms. Jones in the year of sale.   There are certain capital gains exemptions available to Canadian Controlled Private Corporations mentioned below in the Corporation section.

From an income tax perspective, Ms. Jones continues to file her T1 Individual Income Tax Return and report her business income using form T2125 Statement of Business or Professional Activities.  However, her tax return is not due every year until June 15th, a benefit of self-employed and sole proprietor filers.

Ms. Jones personal income tax and CPP on self-employed earnings in 2022 would be as follows:

Gross billings$235,000.00
Expenses – cash-$30,000.00
Expenses – CCA allowed1-$5,000.00
Net business income2$200,000.00
Canada Pension Plan (“CPP”)    on self-employment income  $7,508.90
Federal Tax$40,338.02
Ontario Tax$24,588.56
Total payable$72,435.48

Effective tax rate ($72,435.48 ÷ $200,000.00 = 36.2%3

In the future, if Ms. Jones wishes to sell her business, she must sell the assets of the business to any potential buyer.  It can be difficult to find a buyer for the assets only but not impossible.  Some major brands, like to buy assets of businesses that compete or that are complimentary to their business and absorb the purchased business’ client list into its existing business.  However, a lot of  individual Canadian buyers prefer to buy the shares of the business and gain control of the new business and its assets as the new controlling shareholder.

As a sole proprietor, Ms. Jones will have capital gains or capital losses, recaptured depreciation, and terminal losses on the sale of the assets of her business.  This will occur regardless of how long she has spent building up her business.  Ms. Jones’ tax bill on selling her sole proprietorship’s assets could be substantial.   As we will see below, this is another major difference and advantage of incorporating a business over operating as a sole proprietorship.

Corporation

To operate her business under a corporation structure, Ms. Jones will need to incorporate a company in Canada, either provincially (with the Ontario business registry) or federally (with Corporations Canada).  The online services provided by  the Federal Department of Innovation, Science and Economic Development Canada are very useful and easy to use. 

Most business owners use a service provider (typically a lawyer or accountant) to incorporate their business and maintain it annually or on an ongoing basis.  The costs for the set up and maintenance vary greatly but usually start around $300 to start and about that much annually.

Ms. Jones searches for a name she wants to use and adds “Inc.”4 (for incorporated) at the end of the name to signify that her business is a corporation.  Let us assume that she chooses “Jones Inc.” as her new corporation’s name.  She opens a bank account under her corporation’s name. 

The main benefit espoused by those recommending incorporation as a mode of operating a business in Canada is the limited liability of the business owner.  What does this mean?  It means that if the business, operating as a corporation is sued by an aggrieved party and the corporate business loses its case in court, the claim is limited to the assets of the business.  In theory, no further liability for amounts in excess of the assets can be claimed from the shareholders of the corporate business provided their shares have been fully paid up at the time of the suit (which is normally the case).

If Ms. Jones wishes to expand her business in the future by finding investors, she has many options on how to structure the investment interest such as issuing shares (common or preferred) or issuing convertible debt.  However, she will risk losing control of her business whenever she allows additional owners or investors. Moreso than with a sole proprietorship.

Assuming that Ms. Jones wants to keep all of her start-up expenses in the corporation5 and take out only her net business earnings, Ms. Jones’ compensation / dividend available would be $200,000.00.

If Ms. Jones pays herself all the amount available as self-employed earnings6, her earnings would be $200,000.00.  Note that Ms. Jones is in essence self-employed rendering services to her corporation at times and places determined by her.  Therefore, she pays only self-employed CPP premiums on her earnings paid from Jones Inc.

For $200,000 of payments from Jones Inc.7, Ms. Jones’ income taxes would be:

CPP on self-employed earnings$7,508.90
Federal Tax$40,338.02
Ontario Tax$24,588.56
Total payable$72,435.48

Effective tax rate ($72,435.48÷$200,000.00): 36.2%

If Ms. Jones pays herself all the amount available as dividend, her dividend would be $175,600.00 since her corporation would need to pay income taxes on its net income and distribute the net (after deducting income taxes):

Taxable Income of corporation$200,000.00
Federal corporate income tax$18,000.00
Provincial corporate income tax$6,400.00
Available for dividend$175,600.00

For $175,600.00 of ineligible dividend, Ms. Jones’ income taxes would be:

Taxable amount on Ms. Jones tax return$201,940.00
Federal Tax$24,425.52
Ontario Tax$20,154.01
Total Ms. Jones personal tax payable$44,579.53
Total tax paid$68,979.53

Effective tax rate ($68,979.53 ÷ $200,000):  34.5%

Thus, there is a 1.8% ($3,455.95) benefit to operating Ms. Jones’ business as a corporation and paying all net amounts from the corporation as a dividend.

If Ms. Jones wishes to sell her business, she can sell the assets or the shares of Jones Inc.  If she sells the assets, Jones Inc. will be in a similar tax position as Ms. Jones selling the assets of her sole proprietorship. 

Ms. Jones is a Canadian resident and sole shareholder of Jones Inc.  Therefore, Jones Inc. meets the definition of Canadian Controlled private corporation in the Canadian Income Tax Act8.  If Ms. Jones has owned her shares of Jones Inc. for more than 24 months prior to the sale of the shares, she would be eligible to a lifetime capital gains exemption9 of $971,190 in 2023 on the sale of her shares (the capital gain would be the sale proceeds minus the amount Ms. Jones paid for the shares, $35,000 in our example).  In essence, Ms. Jones could receive $1,006,190 for her shares and not pay any income tax on the sale.  This is the penultimate benefit of incorporating, building, and selling a Canadian business as a Canadian resident taxpayer. 

SUMMARY AND RECOMMENDATIONS

In summary, there are pros and cons to operating a business either as a sole proprietorship or as a corporation. From a taxation perspective, in our example here, the effective rates of tax are:

Sole proprietorship  36.2%
Incorporation-all income taken as self-employed earnings36.2%  
Incorporation-all income taken as dividends34.5%

(Note that we could compute the optimal mix of amounts that Ms. Jones could take as self-employed earnings and dividends, but it makes sense to pay at least the basic personal amount in self-employed earnings – $15,705 in 2024 and the balance as dividend)

Also from a taxation perspective, the taxation on sale of the business would be as follows:

Sole proprietorship:                     Gains are 100% taxable to Ms. Jones

Incorporation-sale of assets:        Gains are 100% taxable to corporation

Incorporation-sale of shares:        Gains can be excluded up to $943,63010

Thus, from a taxation perspective Ms. Jones should run her business through a corporation provided she expects to operate it for more than a few (say two to three) years.  There is more flexibility for reducing the taxation costs of receiving her income from the business through a corporate structure.

If Ms. Jones chooses to start her business as a sole proprietorship and then later decides to incorporate, it is possible to do this without adverse tax effects, but there are professional fees involved with filing forms with the CRA to move the assets from her personal name to the corporation and receive shares without triggering taxable gains or losses in Ms. Jones’ personal hands.

Endnotes

1 Budget 2021 included proposals to provide temporary immediate expensing in respect of certain property acquired by a Canadian-Controlled Private Corporation (CCPC). See Expansion of the Eligibility for Tax Support for Business Investments – Canada.ca

2 This Net Business Income is reported on Ms. Jones’ tax return using Form T2125.

3 Of course all amounts included in the numerator are not “taxes” per se, but for the sake of making our discussion manageable, we will call all the amounts “taxes”, including CPP on self-employed earnings.

4 The Canada Business Corporations Act (R.S.C., 1985, c. C-44) in subsection 10(1) requires that every name of a corporation must contain “Limited”, “Limitée”, “Incorporated”, “Incorporée”, “Corporation” or “Société par actions de régime fédéral” or the corresponding abbreviation “Ltd.”, “Ltée”, “Inc.”, “Corp.” or “S.A.R.F.”.  See https://www.laws-lois.justice.gc.ca/eng/acts/C-44/

5 Often, as a sole shareholder / director, you could choose to incorporate with a nominal $100 share capital and pay the expenses of the corporations first year (or time to earnings) out of your personal savings.  This amount would be a loan to the corporation which you could repay first before having to declare any dividend or salary.

6 In essence, Ms. Jones is providing services to Jones Inc. under a contract for services versus a contract of services (employment).  Generally she, as the service provider determines solely how to deliver the services.

7 Jones Inc. would need to file a T4A Summary with one T4A slip for Ms. Jones by end of February for the previous year’s payments.

8 See subsection 125(7) definitions “Canadian-controlled private corporation”. See Income Tax Act (justice.gc.ca).

9 See subsection 110.6(1) definitions “cumulative gains limit”. See Income Tax Act (justice.gc.ca) or See What is the capital gains deduction limit? – Canada.ca.

10 Subject to conditions, see Endnote 8 and 9 above.