Should you incorporate your small business or farm?
There are advantages and disadvantages to incorporating your business or farm. If you are considering this change you should discuss it with your accountant, as there are many considerations that will be unique to your situation.

If you currently have a sole proprietorship or a general partnership, then, in the eyes of the government your business is considered to be an extension of you. You report the business’s income and expenses on your personal tax return. Any income is taxed at your personal marginal rates and any losses can generally be applied against the other types of income you earn. If someone decides to sue your business, you are personally liable. If your business needs more cash to operate, you must raise it.

If your business or farm is incorporated, this all works differently. Incorporation separates a business from its owner. The business becomes a separate legal entity, a person in the eyes of the law. It can own property and incur debt; it can sue and be sued; it can file tax returns and pay taxes. It can do all these things completely independently of you, the shareholder.

Reasons business and farm owners may incorporate include: 

• Corporations provide the opportunity for the deferral of income tax. This means that you can delay paying some tax until a later time. This could become actual tax savings if you are in a lower tax bracket, or tax rates have gone down when you take the money out of the corporation. If your corporation qualifies for the small business deduction, it will pay tax at roughly 18% on the first $300,000 of taxable income; the same income taxed personally could be taxed at almost 44%.
  
  

Although this looks like a huge savings, you only defer taxes on money that is left in the corporation. If you need all of the company’s earnings for your regular living expenses, then the money must be transferred from the corporation to you (usually through a dividend) and it will be taxed again. This second level of tax is designed to roughly equal the rate you would have paid if you had received the money directly, and not through a corporation.

• A real advantage is that the corporation allows you to determine when you receive income personally. You have the option of taking it at a time when you will pay less tax, or using it to grow your business or farm inside the corporation. If you do not need all of the money to live, the corporation can do many of the other things that you might normally spend personal money on. It can invest, it can hold property, it can use the money to grow and become more profitable. The corporation can do all of these things using an 82-cent after tax dollar compared to your 56 cent after tax dollar!

• Corporations allow for income splitting. This allows the redistribution of income from family members in high tax brackets to those with less income who are taxed at lower rates. Many people can hold shares in your corporation, including your spouse and your children. Dividends are paid to shareholders from the corporation’s earnings. Depending on how the corporation is structured, individual shareholders can have varying levels of control over the business operations (from full to none) and varying rights to receive dividends. A shareholder does not have to be actively involved in the business operations to receive dividends. This allows for many tax-planning opportunities.

There are also non-tax related advantages of incorporation:

• Corporations have limited liability. An individual shareholder’s liability is limited to the amount they have invested in the corporation. If the corporation goes bankrupt you may lose your investment, but unless you have signed personal guarantees you should not lose your house. Corporations have more ability to raise money. They can not only borrow and incur debt, but they can sell shares and raise equity capital. The advantage of equity capital is that it does not generally have to be repaid and incurs no interest. The disadvantage is that any earnings of the corporation will have to be shared with another shareholder. In reality, by issuing shares you are reducing your ownership percentage of the corporation.

• Individuals who hold shares of corporations that qualify as small business corporations or as family farm corporations can qualify for a “super capital gains exemption” on the sale of their shares. If your corporation qualifies, this means you would pay no tax on the increase in the value of your shares up to $500,000 when you decide to sell.
  

Key disadvantages to incorporation include:

• If you have a business that is experiencing losses (as is common in the first years of operation) in a proprietorship, these losses could be used to reduce other types of personal income in the year they happen. In a corporation, losses can only be carried forward or back to reduce the corporation’s income from other years. If the corporation does not become profitable these losses may never be used, as they can only be carried forward for 10 years and carried back for only three years. If there was no taxable income in these years, the losses will “fall off the table” and disappear.

• Additional maintenance costs are related to a corporation, including increased legal and accounting fees. Corporate records must be maintained and tax returns filed. Corporations, unlike individuals, are not eligible for personal tax credits, so every dollar earned is taxed, albeit at lower rates.

• Personal guarantees of loans and credit agreements are often required, so your limited liability is reduced.

• Overall, incorporation is a more complex business structure. The company has to file its own tax returns, choose a year-end, determine a share structure, and maintain corporate records.

One caution when considering incorporating a farm is that you may want to hold the farmland personally and not transfer it to the corporation. Most farmland qualifies for the capital gains exemption when sold by an individual but it will not be eligible for that exemption if held by a corporation. In short, when thinking about incorporating your business or farm:

Consider the advantages:

• Potential tax deferral
• Income splitting potential
• Limited liability
• Access to capital
• Availability of the super capital gains exemption for qualified businesses or family farm corporations.

Consider the disadvantages:

• Additional yearly costs
• Restrictions on the use of losses
• More complex business structure
• Agreements that restrict the limited liability.

That way you can be sure your business structure is sound!

By Denise Parker, CGA. Originally published in West Coast Farmer (April 2006). For more information, contact your local MNP advisor or Denise at 1.800.444.4070.

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