Tax Consequences of Incorporating Your Small Business

by Craig Anthony

4 min read

Like many small business owners, you started out with an idea and a dream. You probably didn’t give much thought to your business’s legal structure and, by default, you have been probably been operating as a sole proprietorship. Over time, your business has grown, and you have decided to incorporate your business so it can benefit from the legal protection of a company or so you can expand your financing options. This may be a good idea, but the process entails many tax consequences and you will have to make a lot of decisions along the way.

Transferring the Business’s Assets to the Company

Over time, your have acquired many different assets for your business. Whether it is real estate, machinery, vehicles, or inventory, transferring these to a corporation is, to use the tax jargon, a disposition. In simple terms, you and the company are two different persons, and you’re selling the business to the company. Since you are not dealing at arm’s length with the company, the disposition has to be made for fair market value. The company will pay you using shares, debt, or a combination of the two. This disposition has tax consequences for you. Depending on the type of assets, you could have capital gains or losses, taxable income, business losses, or even capital cost allowance recapture. The Income Tax Act offers an important relief provision for handling the disposition. All you’re doing is changing the legal structure of your business; you aren’t really selling it. Tax legislation recognizes that this situation could lead to some unfair results. You can use rollover, which allows you to transfer the business assets at their tax value against shares of the company, thereby canceling any possible gains. To benefit from this rollover, you must expressly choose to use it by completing and filing Form T2057. The form and the accompanying documentation are complex, so you may want to consult a tax professional prior to your transaction.

Owner Remuneration: Salary, Dividends, or Loans?

As a sole proprietor, your personal income was simply the profits of the business. Now that you’ll be a shareholder of a company, there are other means of remunerating yourself that may provide tax advantages. As a shareholder of the company, you can pay yourself dividends from the company’s profits. On the other hand, you could also choose to be an employee of your company and pay yourself a salary. The choice of a salary versus a dividend is usually analyzed on a case-by-case basis. You need to figure out what works best for you and your family as far as regularity of income, registered retirement savings plan contributions, and your personal and corporate tax rate. You could also consider having the company simply lend you money. Shareholders often take advances from the company with little or no interest and no reimbursement terms. As long as the company is solvent, this is legal. However, the Income Tax Act has provisions that transform these loans into deemed dividends if they are not repaid after two years. This is to avoid shareholders simply lending themselves money and never paying taxes on it. For the first two years, however, you can give yourself a tax and liquidity break with this technique.

GST/HST Issues

You must also consider the aspects relating to the goods and services tax and the harmonized sales tax for the disposition of your sole proprietorship to your new corporation. The corporation is considered to be a different legal entity, so you must register it for the GST/HST and all other CRA and provincial accounts. You can’t just use your old registration numbers. In fact, at the end of the process, you’ll probably need to close your personal GST/HST account. The sale of the business to the company is a taxable supply under the GST/HST rules. This means that you should charge the GST/HST to your company and remit it to the government. Your company can claim an input tax credit for the amount paid, but it may take a few months before it receives the money, which can lead to cash flow problems. Here also, the tax legislation recognizes that this is an unfair, and somewhat absurd, situation. In light of this, you’re allowed to make a special election that deems the supply to be made at a value of zero for GST/HST purposes and, in effect, ensures that there is no tax payable. To make this election, you need to use Form GST44. Depending on the nature of your business, there may be several other issues to consider. While all of this may seem daunting, transferring a growing business from a sole proprietorship to a corporation structure tends to be the correct choice. The trick to doing it successfully is to take your time and document your transactions. When in doubt, don’t hesitate to contact the tax authorities and seek clarifications to make sure you understand what your tax obligations are.

References & Resources

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