Corporation or Sole Proprietorship? The Simple Flowchart to Decide Now

Key Takeaways

Incorporating your small business in Canada makes sense if

• you need it for legal protection, or 
• your business has money left over after business expenses, personal spending, and personal savings.  

Otherwise, it’s probably best to remain a sole proprietor/self-employed.

Click here to jump to the Summary and Decision Flowchart to determine if incorporation makes sense for your business.

Introduction

If you've launched a business or if you’re considering doing so, you've likely wondered about the necessary steps to formalize your venture. You might also be thinking about establishing a corporation for your business, especially if you've heard about the tax benefits this could bring.

At first glance, deciding to incorporate your small business seems straightforward: “Incorporate and save big on tax!” That advice is, at best, oversimplified and, at worst, flat-out wrong.

I've spent hours sifting through conflicting advice about incorporating my small business. It’s led me to one important conclusion that I should state up front: having a small business does not mean you should jump through the hoops of setting up and maintaining a corporation (aka a Canadian-Controlled Private Corporation or CCPC).

This is an important point to consider regardless of the nature of your business: whether you just have a side hustle earning you little extra income on the side of your 9 - 5 or if you're a doctor, dentist, or lawyer considering incorporating your professional practice.

For some small business owners, incorporating makes a lot of sense. For others, it doesn’t.

This is a simplified guide written in plain English to help you determine if incorporating is the best choice for you.

This article isn’t a replacement for professional advice you might get from a lawyer or an accountant who specializes in the field. Rather, this guide aims to:

• help you determine when it's appropriate to initiate a conversation with a professional advisor
• equip you with knowledge so you can engage with those specialists in a well-informed manner.

What's the Difference Between a Sole Proprietorship and a Corporation?

In Canada, you have two basic types of business structures to choose from:

1. Sole Proprietorship/Self-Employed: the simplest form of business structure. If you’ve earned any money from your business activity, then you’re technically a “sole proprietor” or “self-employed” right now. No additional paperwork is needed.
2. Corporation (or a Canadian-Controlled Private Corporation - CCPC): a separate legal entity from its owner, who is known as a "shareholder." To establish a corporation or "incorporate," you need to file specific paperwork with either the provincial or federal government.

Banking: No Different

Regardless of your choice, it's crucial to maintain a clear separation between your business and personal finances. This means:

• All business income should be deposited into a separate business chequing account.
• All business expenses should be paid from this account.

This separation is essential for accurate record-keeping and can help with tax preparation. 

Taxes: Very Different

The key difference between a sole proprietorship and a corporation is how they are treated for tax purposes and legal protection.

• As a sole proprietor, you indicate your business income and expenses on your annual personal tax return using Form T2125 (Statement of Business or Professional Activities). You can file your business taxes using tax software like UFile, TurboTax, and Wewalthsimple Tax (previously Simple Tax). You will only file one tax return every year.
• A corporation is a separate legal entity and must file its own tax return. As a shareholder, you'll receive income from the corporation, either as salary or dividends, which you'll report on your personal tax return. You will file two tax returns yearly: one for your business (corporate tax return) and one for yourself (personal tax return).

In essence, the distinction between a sole proprietorship and a corporation is largely a tax distinction for the Canada Revenue Agency (CRA) and a legal distinction for the courts if your business ever gets sued, God forbid.

Structural Similarities and Differences

Your decision to incorporate or remain a sole proprietorship does not impact the day-to-day running of your business. The distinction is primarily for tax and legal purposes, as seen above. 

But regardless of the structure you choose, you should have a separate bank account for your business.

Why You Might Want to Incorporate

According to the CRA, everyone is, by default, a sole proprietor if they conduct any business. Why, then,  would anyone jump through the hoops to incorporate their business?  There are two main reasons a small business owner might want to do so:

1. Legal Protection (Limited Liability)

If someone sues your incorporated business, your personal assets like your house or car are safe; they can only go after what's in your business. 

This type of legal protection is…

• very relevant to businesses like construction companies, which face a higher risk of getting sued due to their exposure to physical dangers, complex contracts, and multiple partnerships.
• less relevant to freelancers and cottage industry owners, such as graphic designers or home-based craft businesses, who are less frequently exposed to lawsuits.
• not very relevant to professionals like doctors; incorporating doesn't shield them from being personally sued for malpractice.

2. Pay Less Tax on Saved Money (Tax Efficiency)

If your company makes more money than you plan to spend, you can potentially leave the savings in your corporation and pay less tax on it. There are a few technical terms that capture this attempt, like “tax deferral” or “income smoothing.”  These techniques ultimately have one goal: pay less tax on the money you save.

Pay Less Tax By Paying Later (Tax Deferral). 

This technique allows you to delay paying taxes on your income until a later year, ideally when you fall into a lower tax bracket. This applies to you if you expect your income to vary significantly over the years, with some high-earning years followed by lower-earning years.

Get Paid Evenly Over the Years (Income Smoothing)

This is very similar to tax deferral with a different impetus - it involves strategically withdrawing money from your corporation in a way that provides a steady personal income stream, regardless of your business' yearly profits. This strategy can help you pay less tax because spreading out your income can keep you in a lower tax bracket. This applies if you want a consistent income each year for personal budgeting or lifestyle reasons, or to maintain consistent taxation, regardless of how much your company makes in a particular year.

Keep More Profit if You Sell Your Business (Lifetime Capital Gains Exemption)

This advantage applies when you make a profit from selling your active business. Some of this profit can be exempt from taxes. This applies to you if you plan to sell your business in the future and want to minimize the tax hit on any profits you make from the sale.

Why You Might NOT Want to Incorporate?

There are two main reasons a person or a small business owner might want to incorporate:

1. You Won’t Pay Less Tax (Tax Neutrality)

People often hail corporations as an ideal means for business owners to pay less tax and have more money in hand. But there are several instances in which that is not the case:

You're Not Saving Anything

The primary financial advantage of having a corporation is the opportunity to pay less tax on the money you save (this is called ‘retained earnings’ in the corporate world). That means if you're spending all of your income on your business, personal expenses, paying off debt, and don’t have money to save, the tax advantages of a corporation don’t apply to you.

You’re Saving Some Money, But Not Enough to Justify a Corporation

Even if you have money to save, it still might not be tax-efficient to have a corporation. It’s generally more tax-efficient to first save money in a personal tax-advantaged account like a TFSA (Tax-Free Savings Account), FHSA (First Home Savings Account), RESP (Registered Education Savings Plan), or RRSP (Registered Retirement Savings Plan) than it is to “keep all your savings in the corporation” (a common rule of thumb you might hear, and one that is often wrong).

You Have a Regular "9 - 5" Job

If your business is more of a side hustle or is still in the early stages, operating as a sole proprietorship could be more tax-efficient.  Sole proprietors can offset their business losses against other income (like a full-time job), reducing their overall tax liability. This is especially useful to you if you’re in the early stages of your business and your business expenses exceed your business income (i.e. your business is currently losing money).

Side Hustle Offset: Suppose you have a full-time job earning $70,000 annually and a side business that incurred a $2,000 loss in its first year. As a sole proprietor, you can deduct this loss from your salary, reducing your taxable income to $68,000.

However, if you incorporated your business, you couldn't use the loss to offset your personal income. You'd still pay tax on the full $70,000 salary, resulting in a higher tax bill. This ability to offset losses is a key reason a sole proprietorship can be more tax-efficient for a side business, particularly in the early stages.

2.  Incorporating isn’t Worth the Cost

Setup Cost ($500 - $2000 incorporation fees)

These fees cover the creation of your corporation, which might include legal fees, government filing fees, and services like drafting the articles of incorporation. The fees vary by province and the complexity of the corporation you're setting up. Lawyer fees can add up, especially if your corporation's structure is complex. Some people choose to use an online service like Ownr.co, which can provide a cost-effective solution for straightforward incorporation.

Maintenance Cost ($750 - $5000/year)

While you can file your corporate taxes using a DIY online tool like TurboTax Business, many corporation owners choose to hire an accountant. Corporate taxes can be complex, and mistakes can lead to penalties or lost opportunities for tax savings. Choosing an accountant with experience with businesses similar to yours is often beneficial, as they will be familiar with industry-specific tax issues.

Complexity Cost

Incorporating adds a mental load due to the need to understand corporate structures and their unique tax implications. While learning these new concepts is achievable, it demands your time and attention. 

The simplicity of a sole proprietorship shouldn't be understated. It allows for straightforward financial management and less administrative red tape. In personal finance and business alike, simplicity often leads to clarity, efficiency, and peace of mind.

Common Questions and Misconceptions

1.  How do I get a business name without incorporating it?

By default, the business name of your sole proprietorship is just your legal name.  If you want to use a different name officially, you register what's known as a "trade name." Here are the steps:

1. Choose a unique trade name that you want to attach to your business. 
2. Conduct a Nuans search to ensure the trade name is not already used by another business. Nuans is a Canada-wide corporate and business name registry.
3. If the trade name is available, you can register it with the appropriate provincial authority. The process and fees vary by province.

2.  Do I need to be incorporated to open a business bank account?

No! 
Whether you choose to structure your business as a sole proprietorship or a corporation, it's crucial to have a separate business chequing account. This account should be the repository for all business income and the source for all business expenses. Keeping your business and personal finances separate is essential for accurate record keeping and can simplify your tax preparation process.

3.  Can sole proprietors deduct business expenses like corporations?

Yes. 

 It's a common misconception that only corporations can deduct business expenses. The reality is sole proprietors are equally entitled to deduct legitimate business expenses, much like corporations. The process of tracking and deducting business expenses can significantly reduce your taxable income, a benefit that is not exclusive to corporations.

4. Does incorporating my small business reduce personal income tax?

No.

In Canada, the government has used a system called 'tax integration' since the 1970s, which, in principle, aims to make tax the same no matter your business structure. In the end, whether you’re a sole proprietor or the owner of a corporation, the tax you pay on personal income is about the same.

5. If I incorporate, can I pay myself “dividends” instead of a “salary” and pay less income tax?

No. 

It's important to understand the difference between a "salary" and "dividends" when you incorporate. If your corporation pays you a "salary," you're being compensated as an employee. This means you're on the payroll, receive regular income, and have taxes withheld. After filing your personal tax return, you may even receive a tax refund, just like any other employee.

On the other hand, if your corporation pays you "dividends," you're receiving money as a shareholder. Dividends go directly into your personal bank account, bypassing the usual payroll and tax withholding processes associated with a salary. However, you're still required to pay taxes on dividend income eventually during tax season. 

Ultimately, due to the 'tax integration' model, you'll end up paying roughly the same amount in income tax in the end.

Both salary and dividends have their advantages, which is why owners of more profitable corporations often pay themselves both a salary and dividends.

6.  If I pay myself dividends, won’t I save myself thousands of dollars by avoiding CPP contributions?

This is partially correct.

If your corporation pays you in "dividends," you can indeed avoid contributing to the Canada Pension Plan (CPP), a strategy I refer to as the "CPP Dodge." 

To understand this, let's quickly go over CPP. In 2023, the contribution rate was 11.9% of your income, up to a maximum contribution of $7508.90. If you're a salaried employee, you and your employer each pay half of this rate, 5.95%. But if you're a sole proprietor or if you're incorporated and pay yourself a "salary," you're responsible for the full 11.9%.

If you're incorporated and choose to pay yourself in "dividends," you're not required to contribute to CPP. Some see this as a compelling reason to incorporate.

There is an ongoing debate about whether or not CPP contributions should be thought of as a “tax” (because the government requires that you pay it) or as a low-risk “investment” (because, in retirement, you are paid back CPP based on how much you put into it). 

There are two important points to consider here:

1. If you have a full-time job and your business is a side hustle, your primary job's CPP contributions should cover you. Any extra CPP payments from your business would likely be minimal, so incorporating just to avoid CPP might not make sense.
2. If you're incorporated, don't automatically choose dividends over salary to dodge CPP. The decision is complex and depends on various factors. A salary can offer benefits like contributing to your RRSP and potentially lowering your personal income tax rate. If you decide that a salary is the best option, the "CPP Dodge" becomes irrelevant.

7.  Does incorporating provide additional avenues for reducing taxes through “income splitting” with family members?

Not anymore.

In the past, corporations had a significant advantage in this area. They could use a strategy known as "income sprinkling" to distribute a corporation's income among family members in lower tax brackets, thereby reducing the overall tax burden.

But in recent years, the Canada Revenue Agency (CRA) has implemented strict rules to neutralize this advantage. These changes took effect starting from the 2018 tax year. Now, any salary or dividends paid to family members must be reasonable for the work they do actually do in the business.

In addition to these changes, the CRA introduced the Tax on Split Income (TOSI) rules. TOSI doesn't prevent you from employing family members under 25, but it does change how their income is taxed. If TOSI applies, certain types of income they receive, like dividends from a family business, can be taxed at the highest marginal rate. This rule was designed to prevent shifting a significant portion of income to younger family members who are in lower tax brackets.

So, while both sole proprietors and corporations can employ family members and pay them a reasonable salary for the work they provide the business, these rules have leveled the playing field. This strategy can help your family pay less tax overall, but incorporation doesn't provide any specific advantage in this regard anymore.

When Does Incorporation Make Sense?

Incorporation Equation

How do we consolidate all these factors to decide on incorporation? While most online resources list the pros and cons of incorporation, as we've done above, they don't often provide a practical framework to help you efficiently determine whether remaining a sole proprietor or setting up a corporation is the best choice for you.

 Here’s a shortcut that can help cut through the noise: 

Cost > Legal Protection + Tax Efficiency → Stay a Sole Proprietor

Cost < Legal Protection + Tax Efficiency → Incorporate

You can use this framework on your own, or you can use it with the tax professional advising you. If you’re being advised to incorporate, ask to be shown how the legal protection + tax efficiency of doing so is greater than the cost of setting up and maintaining incorporation. 

 Remember that incorporation doesn’t just have a financial cost to set up and maintain. It also has a mental cost - the cost of complexity. If you are discussing this equation with a financial advisor, they may or may not consider that factor fully. But you should.

When Should He Incorporate? An Example

When a small business launches, it usually doesn’t make sense for the owner to incorporate immediately (unless it needs the legal protection afforded to it by a corporation). As the business grows, however, that can change.

Stage 1: Starting a Small Business

Fahad is passionate about fitness. So he’s decided that instead of occasionally helping friends and family with workout plans and training, he will professionalize his services into a proper business: Falah Fitness. He’ll lead group fitness sessions in his garage-made fitness studio, offer one-to-one private training, and facilitate nutrition plans for his clients.

 Fahad has chosen to maintain his regular job and to do Falah Fitness work in the evenings and on the weekends.

He plans to save all of the income from Falah Fitness to build his personal emergency fund.

Incorporate?

No.

Rationale: At this stage, all of Fahad’s net income is being used for personal, short-term savings. Incorporating offers no tax efficiency.

Stage 2: Profitable Business, Growing Savings

Four years have passed since Fahad launched Falah Fitness, and it’s doing well: his business is becoming increasingly more profitable. He’s maintained his regular job, though he’s cut his hours to give him more time to work on Falah.

His personal emergency fund is fully funded, and all of his excess income is flowing into his TFSA. He has a lot of contribution room in his TFSA from years of not contributing.

Incorporate?

No.

Rationale: Falah Fitness is making Fahad enough money to build his personal tax-advantaged accounts. But he still has room to store savings in his TFSA. After maxing out his contributions to his TFSA, he should plan to begin to save in his RRSP.

Stage 3: Growing Business, Maxed Personal Savings

Six years have passed since Fahad launched Falah Fitness, and as the business continued to grow, so too did Fahad’s savings. He’s now running Falah full-time because not only is the business generating income for his salary, but it’s also generating enough for him to max out his TFSA and RRSP. He’s since had a child, and so he’s also maxing out his child’s RESP (Registered Education Savings Plan).

Falah Fitness still has money left over even after all of that savings.

Incorporate?

Yes.

Rationale: Fahad has maxed out his personal savings and must now choose where to build future business savings. This is where having a corporation for tax efficiency becomes quite beneficial. By incorporating, Fahad can retain the excess earnings within the corporation and pay a lower corporate tax rate. This allows more funds to be available for reinvestment in the business or future dividend payments.

Summary and Decision Flowchart

Navigating the decision to incorporate can feel complex because it requires balancing legal protections, tax efficiencies, and costs. If you're just starting your business or are unsure about incorporating, it's often best to remain a sole proprietorship.

Here’s a decision-making flowchart that guides you through key considerations, helping you determine if incorporation is the right choice for your business.

Resources and References

Besides the CRA’s own website on this subject, I found the following resources helpful:

Avalon Accounting - Should I Incorporate? The Pros and Cons of Incorporating Your Business

Breaking Bad Debt - Should I Incorporate? The Basics of Incorporation for Physicians

Jessica Moorehouse - The Pros and Cons of Incorporating Your Business in Canada