So you have a small business idea that you have in mind or that you have already had time to develop and started to make a few bucks from it. Now that the tax season is over, you are probably thinking of the implication of having this new revenue added to your next income tax report.
Some people will advise you to incorporate right away; others will tell you that you are better off staying as a self employed. Depending on your case, both approaches can be good. In order to show you the benefits and flaws of a corporation, I’ll explain why we decided to go that route so early in our process. Please note that my experience is related to a Canadian Corporation so there might be some differences when creating a LLC in the US. However, the factors influencing your decision will remain about the same.
Tax implications of a corporation
If you ask to any tax expert that follows the letter of the law, they will tell you that there are no tax advantages in creating a corporation when compared to earning your extra revenue as a self employed person. Technically, if you earn income in a small business, you will be taxed at 19%. If your corporation distributes a dividend, you will be roughly taxed at 30% (depending your marginal tax rate and the province where you live). Therefore, an income of $100 will result in a payment of $19 to the Government when earned in the company and you will need to add an extra $24.30 ($81 * 30%) in personal tax for the dividends received. The total tax paid is then 43.3%. This is probably a similar tax scenario as if you would earn this income directly as a self employed (taxed at your marginal rate).
Cost of creating a corporation
The good news when you are self employed is that you earn directly in your hands the income and you don’t have any expenses to incur in the “creation” of your small business. You charge your client under your name and you get paid the same way. At the end of the year, you only have a few more lines to complete in your personal tax report. That’s all.
This is a different ball game when you look at a corporation. The first thing to consider is the incorporation cost itself. It could easily lead to fees of $1,000 since you need a lawyer to create your corporation and register it in your province/state. But you are not done with costs. You will also have to consider accounting fees for the following tasks:
– Annual financial statements
– Separate tax reports
– Bookkeeping (you need to keep track of all the credits and debits in your books)
– Updating your minutes book (with regards to shares and shareholder convention)
You can surely do most of this yourself but you will waste your biggest asset: TIME! In my case, I pay a little bit less than $200 per month for bookkeeping and accounting advice (I can call my accountant anytime) and I pay an extra $1,000 for filing the tax report and completing the financial statements. While the cost is significant, it saves me a lot of time (and I hate bookkeeping anyway!).
A Corporation is another person
This is probably one of the biggest advantages of creating a corporation: the corporation itself is considered to be a legal entity. This person will earn its own income, file its own tax report and will be responsible by itself (in case of a lawsuit). If you are working self employed, you can’t really separate your activities from yourself. This may lend some problems in the future (if you want to have a partner for example or if you are looking for financing; you will be directly held responsible for your company’s debts).
The Tax trick with corporation
While there is no “true” tax advantage of having a corporation, the main difference between the corporation and yourself is that the corporation is spending money before taxes while you are spending money after taxes. This allows you to defer taxes over time and use some expenses to pay fewer taxes. For example, we are allowed in Canada to use amortization to decrease the value of company assets (such as computers, web properties or real estate properties). The Amortization is a “paper loss” which saves you from paying taxes right away and defers them over time. This is in such situation where you can have a “tax advantage” of creating a company.
When should you create a corporation?
There is no definite answer to this question. However, there are a few indicators that can tell you that it is the time to create your corporation:
a) If you have a partner
With a shareholder agreement and a good corporation, everything is much easier with a partner. Having a partner myself, I saw the immediate benefit of creating a corporation at the very beginning of our partnership. We wanted everything to be separated equally and we wanted to make sure that we planned an “exit strategy”. Now we know that if we split or one of us passes away, we have values and mechanisms ready to split the corporation accordingly.
b) If you start making serious money
Some people will advise you to consider incorporating when you are making around 30K with your small business. This sounds reasonable as 30K would justify accounting expenses while also be big enough to weigh on your personal tax (probably around 40% if you add another 30K to your income).
c) If you plan to grow this into a real business
Having a corporation also send a clear message to your customers: you are serious about doing business. Since it requires fees and a structure, you show people around you that you really want to grow and do business for a long time. This is definitely a sign of involvement and motivation.
d) If you are already making a good salary with your day job
This is one of the reasons that motivated me the most to create a corporation: I’m already sitting in a higher tax bracket, I don’t need to pay more taxes than I already do. Since I don’t need this money to live, I would rather have it taxed at 19% and keep it within the corporation to grow or to simply defer taxes in time.
Final Thoughts on Creating a Corporation
I hope I gave you a few guidelines as to when to create a corporation for your small business. When we officially partnered up back in 2008, we were not making much money (about $200 per month) but we really wanted to make a statement upfront and kick our ass into the business world. In our case it was definitely a good idea!
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