“With great power comes great responsibility”. Those were the last words said by uncle Ben to his nephew Peter Parker (aka Spider-Man) in the iconic 2002 Marvel movie featuring Tobey Maguire.
Now hold on a second. We are not talking about protecting society from crime syndicates and fighting bad guys with incredible superpowers in this article.
But the quote is very fitting - because as an owner of a business that services clients and generates revenues, you’ve got the great responsibility to make the best decisions to protect that business from the evils of tax and liability.
Luckily, no Spidey Senses are needed.
In the business world, entrepreneurs can take advantage of different business structures in order to formalize their idea, get recognized by their clients as legitimate entities, get paid, control tax and other obligations.
Two such structures that you will probably come across, if you haven’t already, are Sole Proprietorship and Corporation. The question is: what’s the difference?
In this article, we’ll break down the advantages and disadvantages of Sole Proprietorship and Corporation business structures, and help you choose the right one for your own business.
What is Sole Proprietorship?
Sole proprietorship is a business structure that allows an individual (sole) business owner to formalize their product or service offering. It’s the most basic form of business ownership, and creates a simple way to report incoming revenues, deduct expenses, invoice clients, and file tax returns.
Example: Joel is a full-time employee for a software company. He also creates custom-built websites on weekends and sells them to small businesses. Joel decides to formalize his side hustle as a business, and registers a sole proprietorship for his website business.
What is Corporation?
Corporation is a legal entity that is separate from the actual business owner. Instead of representing a corporation personally, an entrepreneur owns the corporation. Ownership in the corporation is represented by shares. Multiple owners may exist - such as co-founders, investors, and sometime strategic partners may all own a portion of the company.
The biggest distinction from other business structures is that a corporation is completely separated from its owners, meaning that it’s the corporation - not the owners - that earns revenues, incurs expenses, borrows money, gets investment capital, and employs staff.
For example: Bill and Paul decide to start a computer repair business. They incorporate a business - and use it to lease office space, buy basic repair equipment, and hire two associates to help out with marketing and technical work. At the end of the first year business earns 10 million dollars in income after expenses - and Paul and Bill decide to pay themselves and two associates a salary of $50,000 - keeping the rest of the money in the business.
Differences between Sole-Proprietorship and Corporation
Now that we’ve learned the definitions, let’s explore how two of these business structures differ from one another.
Let’s start with who owns the business in each case.
When Sole Proprietorship is created, the person that creates it becomes a 100% and sole owner of that business, as the name suggests. There is no need to issue shares and allocate assets. Ownership in Sole Proprietorship is not meant to be transferred or sold to others, due to unfavorable tax consequences.
Corporation is owned by shareholders - the owners of shares. When a company is incorporated, it issues shares to allocate ownership to its shareholders. Two business owners does not mean a company is equally split between the two. Shares also represent the value of the business owners are entitled to. Shareholders are free to sell their shares to other investors if they decide to exit the business.
For example, Bill might actually own 80% of the computer repair business, because he put in more capital and effort into starting the business than Paul did
Tax consideration is one of the reasons why business owners decide to register their business.
There is a difference between how taxes work for people who operate an unregistered business, business registered as a sole proprietorship, and a venture registered as a corporation.
Unregistered business owners have to declare side income as their personal income. There is also little to no ability to reduce that income by declaring expenses. It’s not unlike being an employee, where your salary can not be reduced through expenses like food and transportation. That means that close to 100% of your income is taxable at the end of tax year.
Business owners that operate a sole proprietorship, however, have the ability to deduct certain expenses to reduce taxable income. Things like phone bills, marketing costs, business attire, transportation costs, office costs (including home office) and supplies can be deducted, among many other expenses. The net earnings are reported as a part of your personal income tax return. If your sole proprietorship is losing money (expenses exceed revenues), that loss may even be used to offset earnings from other activities (such as a part-time job) at the end of the year.
Incorporate Business has additional tax benefits, compared with Sole Proprietorship. Not only can a corporation deduct all the expenses and more, they may also qualify for small business credits and even take advantage of reduced tax rates optimized to support small businesses.
For example, a corporation would enjoy a tax rate of 13.5% on any income below $500,000 / year, while the same income will be taxed close to 50% for sole proprietors.
Another important consideration that differentiates sole proprietorship from a corporation is the liability (or risk) attribution.
In sole proprietorship, the owner is personally responsible for all obligations. They take on the liability of a bank loan, an employment commitment, or a lawsuit. It’s very important to understand that such liability attribution puts entrepreneur’s personal assets at risk too. It’s usually not an issue when pursuing a side hustle or a consulting project. However, the bigger the business becomes, the more risk an individual owner is taking by keeping it. If sole proprietorship needs to declare bankruptcy, it will be reflected on the owner's credit history.
An incorporated business shields its owners (or shareholders) from most of the liability incurred in the business (except for criminal activity). Corporation creates a self-contained “bubble” to wrap all activities, assets, and liabilities. Thus, if the business is sued or penalized in the future, company employees, directors, and shareholders are not personally liable. If the corporation declares bankruptcy, it will not affect credit history of shareholders (but it might affect their professional ability to take on debt or raise equity capital in the future)
By now you’re probably wondering why wouldn’t all entrepreneurs simply incorporate their businesses. This is because incorporation means more work from the legal, accounting, and corporate filing stand-point, compared to a sole proprietorship.
When you run a sole proprietorship, all tax activities are reported in your own personal income tax return. That means that there is no need to hire a Corporate Accountant: a personal tax service will most likely be able to assist you. Sole Proprietorship also means that you won’t need to create and maintain a lot of legal paperwork. Sole Proprietorship also doesn’t require annual renewal. Instead, you would need to renew Sole Proprietorship once every 5 years.
When it comes to incorporation, one of the biggest burdens is the legal, administrative, and accounting workload that comes with having this type of business structure. Government requires business owners to conduct business name registration, file articles of incorporation, create shareholder agreements, issue shares, create director resolutions, and fill out a bunch of other documents - in order to maintain a compliant Minute Book.
Corporations also need to be kept in good standing by filing annual returns with the government. And to take advantage of low tax rates, you would likely need to hire a corporate accountant to categorize and file taxes accordingly.
Similar to how running a corporation means more work from the legal and accounting standpoint, it’s also more expensive to run a corporation compared with a Sole Proprietorship.
Sole Proprietorship registration cost varies between provinces, but is usually a small fraction of the cost of incorporation. For example, Ontario sole proprietorship registration costs $8 for Name Search and $60 to register. It’s also cheaper to maintain from a legal and accounting perspective.
Federal Corporation costs $13.80 to reserve a legal name and $200 to register. At the very minimum, you need to renew corporate registration once a year for $12. This cost really starts to add up, when you consider all the legal paperwork that needs to be drafted. Incorporation Packages are very costly when hiring a traditional law firm, where lawyers charge $250-$500/hr to fill out forms on your behalf - and it’s quite common to anticipate a $1000-$2000 bill just for filing articles of incorporation and preparing a minute book. Fortunately, it’s much more affordable when incorporating with coSquare - where you can get Bay St. quality paperwork and incorporation filed for a flat fee of $99.
There is also a cost associated with hiring a corporate tax account to classify all the expenses and to file a corporate income tax return at the end of each year. If your business generates revenues and incurs expenses, it may cost upwards of $1,000/year to file tax returns.
Which business structure is right for you?
So with all these considerations, you must be wondering whether to choose Sole Proprietorship or Corporation.
Both have its advantages and disadvantages. In my personal opinion, it’s better to stay a Sole Proprietor if you’re running a small business or a side project, and incorporate as soon it becomes disadvantageous for tax reasons.
For example, if you’re running a small web design agency, work for yourself, and make $40,000 / year helping other website owners improve their user experience - then it’s probably not worth creating a corporation. You will be able to be more flexible, save on legal and accounting costs, and spend more time with your customers.
However, if you web design agency grows from $40,000 to $150,000, and you decide to hire 2 employees to help out with day-to-day tasks, while you spend your days doing business development, hunt for office space, and consider the possibility of applying for funding or government subsidy - it’s time to incorporate. More favorable tax rates in this case will be enough to compensate for increased costs associated with administrative work, while allowing for more flexibility and better liability protection. So you can sleep well knowing your personal savings are not in danger. 😊
For your simplicity, you may try Managed Corporation plan from coSquare that allows you to offload all legal and administrative work to us, for a small monthly fee of $29.
Can I start a Sole Proprietorship and convert it later into a Corporation?
Yes. In fact, many small businesses that don’t require maintaining multiple business owners, filing for intellectual property protection (think high-tech), or raising capital choose to start with Sole Proprietorship and later file for Incorporation.
There is no way to roll a sole proprietorship into a corporation. You would have to first register for a sole proprietorship. As your business grows, and it makes sense to create a corporation - you can then use your existing business name to register a company.
It’s an ideal scenario If you anticipate starting small, and then growing your business throughout the years.