The first thing a business owner who is considering incorporation should know is what a corporation is and why someone might choose to operate a business through this type of entity.
What is a corporation?
A corporation is a business that has been federally or provincially incorporated. When a business owner incorporates his/her business, he/she creates a new legal entity that is separate from him/her. As a result, the corporation has its own rights and responsibilities, just like a person – it can buy and sell property, borrow money, enter into contracts, sue and be sued, and must file taxes all in its own name. A corporation is owned and controlled by its shareholders, its business activities are managed by its board of directors, and its day-to-day operations are overseen by its officers.
What are the benefits of incorporating?
Incorporating a business comes with many potential benefits, including: (a) protection against liability; (b) protection of the corporation’s name; (c) tax benefits; (d) extended life of the corporation; and (e) access to funding and suppliers.
Protection against liability
In most cases, a corporation protects its owners, directors, and officers from liability. Unlike a sole proprietor, who conducts business and enters into contracts under his own name (which puts his personal assets at risk), the owners, directors, and officers of a corporation conduct business through and enter into contracts under the corporation’s name, which puts the corporation’s assets at risk instead.
There are a few limitations to this protection against liability. For example, if a shareholder personally guarantees a loan for a corporation and the corporation defaults on that loan, that shareholder will be personally liable for the debt. Shareholders may also be held personally liable for a corporation’s unpaid taxes and fraudulent activities. Directors may be personally liable if a corporation fails to pay employee wages or does not make its required employee deductions, withholdings, or remittances. Directors and officers are also liable for damages resulting from their failure to act honestly and in good faith with a view to the best interests of the corporation and to exercise the care, diligence, and skill that a reasonably prudent person would exercise in comparable circumstances.
Protection of a corporation’s name
Incorporating provides protection against other business owners who may attempt to incorporate within the same jurisdiction under an identical or nearly identical name. If a business is incorporated in Ontario, no other business may incorporate in Ontario under the same name, and if a business is incorporated federally, no other business may incorporate anywhere in Canada under the same name.
Corporations and their owners generally enjoy certain tax benefits. For example, (a) business income that is reinvested back into a corporation will be subject to corporate tax rates, which are lower than individual tax rates; (b) a corporation that qualifies for the “Small Business Deduction” will see a portion of its annual taxable income taxed at a reduced corporate rate; (c) some owners of small businesses who sell their shares may qualify for the “Lifetime Capital Gains Exemption”; and (d) corporations can be structured to permit income-splitting with spouses and adult children.
Extended life of a corporation
Unlike a sole proprietorship which automatically dissolves when the sole proprietor dies, a corporation continues to live beyond the lives of its owners. When the only shareholder of a corporation dies, his/her shares may be transferred to the beneficiaries of his/her estate or they may be sold to another party, pursuant to a shareholders’ agreement or other arrangement, and the corporation will continue to exist until it is dissolved.
Access to funding and suppliers
Incorporating can add to a business’ credibility, which can make it easier to obtain financing from potential investors and lenders and to negotiate with suppliers. A corporation’s by-laws or a shareholders’ agreement can also provide for the right of the corporation to raise additional capital through shareholder loans. Further, the Canadian government and some financial institutions offer certain loans and grant programs specifically to incorporated businesses.
Conclusion and next steps
The first step to incorporating is understanding what incorporating means and how it might be beneficial to you. It is equally important to be aware of the costs and legal obligations that come with owning and operating a corporation. Stay tuned for Part 2 of this blog series, which addresses some key filing, governance, and administrative obligations for corporations.