My name is Mark Goodfield and I am a tax partner and the managing partner of Cunningham LLP in Toronto. This blog is about income tax, business, the psychology of money and investing topics and is meant for taxpayers no matter their income bracket, but in particular for high net worth individuals and entrepreneurs who own private corporations. I also blog about whatever else crosses my mind; I have to entertain myself. This is my personal blog and the views and opinions expressed in this blog do not reflect the position of Cunningham LLP. I am blunt and opinionated (at least for a Chartered Professional Accountant). You've been warned.

The blogs posted on The Blunt Bean Counter provide information of a general nature and should not be considered specific advice, as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Monday, December 2, 2013

Should You Transfer Your Sole Proprietorship into a Corporation?

To minimize costs and test the economic waters, many Canadians start their own business as a sole proprietorship. If your business proves successful, you are then faced with the decision of whether
or not to incorporate. Today’s post discusses the income tax and business issues you must consider before deciding to move from a sole proprietorship to a corporate structure.

Legal Liability


As a business grows, sales tend to become larger and the consulting engagements more complex. Consequently, the risk of a product flaw or error becomes greater. As a proprietor, any legal action taken against your business places all your personal assets at risk, including your home (if it is in your name and not your spouses). Therefore, the decision to incorporate often makes sense just to ensure your personal assets are protected.

Until you incorporate, it is vital to ensure you maintain adequate business insurance and minimize the assets held in your own name.

Profitability and Tax Rates


As a proprietor, you must report your business income on your personal income tax return. As such, your profits are taxed at your marginal income tax rate. If you require all your business profits to fund your lifestyle; it does not make sense to incorporate your business (subject to other issues I will discuss below). However, if your business has become profitable enough that you do not need all the income generated, incorporation begins to make some sense as a tax deferral mechanism.

For example: In Ontario, the first $500,000 of active business income is taxed at only 15.5%. If you need $80,000 to live on and can leave the rest of the money in the corporation, you would defer at minimum 20% in income tax by utilizing a corporation (The marginal rate of income tax in the $80k range is approximately 35.5% vs. 15.5% corporate rate). If you are in the highest Ontario personal marginal rate you could be deferring upwards of 34%. By the way, active business income means what it sounds like: running a real business - manufacturing, wholesale, consulting, etc. A passive business earns income from stocks, rental properties, etc.

Capital Gains Exemption


One of the main advantages of incorporating is potentially being able to access the capital gains exemption for qualified small business corporation shares. The exemption is currently $750,000 per shareholder, but is scheduled to rise to $800,000 beginning January 1, 2014. Based on the 2014 exemption, a husband and wife who are 50/50 shareholders could sell their business for $1,600,000 and not pay any income tax, subject to the criteria discussed below. If you think your company may be worth millions in the future, you may even want to consider utilizing a family trust that would provide an exemption of $800,000 for every family member you include in the trust.

The criteria to determine whether shares qualify for the capital gains exemption are very complicated. The rules look back at the last twenty-four months prior to a sale and at the company on the date of the sale. In addition, the more successful you are, the harder it is to qualify. If you have excess cash and investments in the company you may fall offside the rules. I will discuss these confusing and complicated rules in a separate blog post in the future; but keep in mind, tax planning is imperative to ensure you qualify for the capital gains exemption.

Income Splitting


Income splitting opportunities for a corporation are often over-estimated. However, if you include your spouse as an owner, there may be significant income splitting benefits through the use of dividends. Dividends may be based on pure ownership (i.e.: Mr. A and Mrs. A each own 50%, so they each get 50% of any dividend paid) or you may be able to structure the corporation with discretionary shares that allow the dividends to be paid in any proportion to either Mr. A or Mrs. A (i.e.: 100% of the dividends are paid to Mrs. A and none to Mr. A). This type of structuring is complex and again you need to ensure you get proper tax and legal advice before utilizing a discretionary share structure.

How Do I Go from a Sole Proprietorship to a Corporation?


There are specific rollover provisions contained in Section 85 of the Income Tax Act that allow for you to transfer your sole proprietorship to a corporation on a tax-free basis. Shares of the corporation must be received on the transfer. The rollover is undertaken by filing Form T2057. Although this is a standard transfer provision, it is fraught with landmines.

The combined legal and accounting fees to undertake this transaction can range from $5,000 to $10,000 depending upon the complexity of the transfer. As such, many people decide to forgo this step, especially when they consider their main proprietorship asset to be personal goodwill (you are  the business and without you, it is worthless) as opposed to business goodwill (the portion of the business value that cannot be attributed to business assets such as inventory and equipment. i.e. The value of your business name, customer list, intellectual property etc). However, if you ignore filing Form T2057, you do so at your own risk.

This is because when you transfer your assets and goodwill from your proprietorship to a corporation, you are deemed to have sold or disposed of these assets at their fair market value. In order to avoid this deemed sale and to ensure you do not create any income or capital gains upon the transfer of these assets, I always suggest filing the tax-free rollover under Section 85.

As noted above, I have had clients argue they have no business goodwill and that all their goodwill is personal in nature. While in some cases there may be some validity to this argument, I think it is penny wise and pound foolish to take the risk that the CRA will deem a large gain on the transfer of your proprietorship goodwill when you can just make the election and eliminate that concern.

Once you have decided to rollover your goodwill to the corporation, it needs to be valued for purposes of the T2057 form, which can be a costly exercise. While not recommended, if you will be issued all the shares of the corporation, accountants may accept a client’s estimate of their goodwill for purposes of the election if it is reasonable and supportable. However, where other family members will become shareholders, a professional valuation is required. For example, if John transfers his proprietorship to a corporation and a valuator determines his shares are worth $500,000, John must be issued special shares worth $500,000 to ensure he has not conferred a benefit on his spouse or children. Once the special shares are issued to John, his spouse, family and/or trust subscribe for new common shares at $1.

It is important to note that I am glossing over several complex attribution rules here and you should not consider including any family member in the new corporation until you obtain proper income tax and legal advice. It is crucial to understand the ramifications of either decision and whether dividends must be paid to you in order to avoid the attribution rules.

Cost and administrative considerations


The cost of maintaining an incorporated company is far more expensive than operating a proprietorship. You must file financial statements with the CRA and the corporate income tax returns are complicated. You require annual legal resolutions and the administration is far more costly. Thus, I would not recommend the use of a corporation (subject to the other factors such as creditor proofing and the capital gains exemption discussed above) unless you could leave approximately $50,000 at minimum, but more like $75,000 of taxable income in the corporation after any salary you require.

Proprietors sometimes have difficulty separating their corporate funds from their personal funds as they are used to taking draws and simply paying tax on their business income. The corporate structure is more formal and personal drawings must be paid in the form of salary with income tax withheld and/or dividends. Both require filing of government forms (T4/T5).

The income tax benefits of a corporation can be significant. However, the transfer of a proprietorship to a corporation is very complex, especially when introducing family members as shareholders. It is thus vital that you engage an accountant and a lawyer to explain all the income tax issues to you before undertaking the transfer.