Why and How to Transition from a Sole Proprietorship to a Corporation

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When starting your new business, it often makes sense to choose the simplest structure which is the sole proprietorship.  This allows you to test the viability of your business idea and to see if the lifestyle and the related stress that goes along with being a business owner suits your personality and is in line with your long term goals.  Alternatively, you might want to keep everything simple and not add any unnecessary complexity.  Registering and  maintaining a sole proprietorship is fairly straightforward ; many business owners don’t put much thought into the financial aspects of it until tax time (when everything becomes a bit more hectic).  Once you have a corporation, however, the level of complexity and commitment increases.

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Why Transition from a Sole Proprietorship to a Corporation?

There are several reasons that you might decide to transition your sole proprietorship to a corporation:

Growth

As your business expands, you might start feeling the strain of its increased complexity. It's probably time to think about moving to a more formal business structure, like a corporation. This shift can help you manage the growing pains by establishing a separate legal entity dedicated to your business. This allows you to get in front of the additional complexities that come with growth.

Necessity

Banks and financial institutions often require a formal business structure like a corporation for financing. This is because they view corporations as more stable and structured. Also, some clients and suppliers might only deal with incorporated businesses, viewing them as more credible and reliable.

tax optimization

• Profit Retention: By incorporating, you can choose to keep more money in the business, which can be taxed at a potentially lower corporate rate, rather than taking it all as personal income.

• Payment Flexibility: As a corporation, you can decide whether to pay yourself a salary or dividends, or a combination of both, which can help you manage your personal and business taxes more efficiently.

Adding a partner

If you’re thinking about adding a partner, incorporating allows you to issue shares and set up clear agreements, which can make the partnership smoother and more manageable.

separate business from personal

A sole proprietorship is simply an extension of an individual while a corporation is a separate legal entity.  This separation protects your personal assets from business liabilities, which is crucial as your operations expand.

Taking advantage of loans, incentives, tax credits

Corporations often find it easier to qualify for government and private financing options, including grants, loans, and tax credits. These resources can be instrumental in growing your business further.

Limited liability

One of the primary benefits of having a corporation is limited liability which means that you are only responsible for debts or liability to extent of the assets in the corporation.  With a sole proprietorship everything that you own is available to someone who sues you.   

Value Creation

A corporation can continue beyond the lifetime of its founders, providing a path for succession or sale. If you ever decide to sell, you could benefit from the Lifetime Capital Gains Exemption, potentially saving on taxes.

For a more in depth discussion, check out our post on reasons to incorporate your small business

Next Steps when switching from a sole proprietorship to a corporation:

Register your new corporation

The first step once you have decided to incorporate is to register your new corporation.  There are numerous incorporation services that can help or you can do it yourself with guidance from Industry Canada and the province in which your business is located.   An important facet of incorporation is deciding whether you want to do it federally or provincially.  The advantage of incorporating federally is that it allows greater flexibility if you want to expand into other provinces or even internationally.  It also gives you some name protection.  Provincial registration is a little less expensive and appropriate if you’re not seeking to build a brand or expand. 

A simple breakdown of the 4 types of tax that every new owner of a corporation needs to know about

Register for new sales tax numbers and payroll numbers

When creating a new corporation for your business, you have to register for new sales tax (GST/HST) numbers and also register for payroll accounts, depending on if you are charging sales tax and have employees, respectively.

Cancel your Sole Proprietorship Registration and tax numbers

Determine if you want to dissolve your current sole proprietorship or keep it running as an inactive business for a little while.  You should however cancel your sales tax and payroll numbers to avoid having to file $0 returns and incur potential penalties if these are not filed on time.

Close your Sole proprietorship Bank account and open a new corporate bank account

Close your business bank account for the sole proprietorship and set up a new bank account for the corporation.  You can continue to use the business credit card although it is better to get a corporate credit card, if possible.

Consider a section 85 rollover

When transitioning your existing unincorporated business to a corporation,  you should consider whether you need to do a Section 85 rollover which is a way of transferring assets from the Sole Proprietorship to the corporation.  This is especially important if you have built a brand or a customer list and your current business has some intangible value in addition to assets such inventory and equipment.  The purpose of a Section 85 rollover is to assess a value for the assets of the existing business , including intangibles and transfer them over at their original cost so that you don’t have to pay capital gains tax.  Many small business owners don’t do this which can be problematic if Revenue Canada decides that your business did have value and consequently assesses tax.  This article explains a Section 85 rollover in greater detail.

Change contracts, billing etc. in favour of the new corporation

If you have contracts with customers/clients that you will be moving over the new corporation make sure that these are updated to reflect the new entity and any other associated changes. 

ensure that You Transition Your accounting Properly

Since a corporation is a separate legal entity, it is best practice to start a new accounting file.  Some business owners continue to use the same accounting file which can result in confusion particularly for tax purposes since tax reporting for a sole proprietorship is different than a corporation.  A corporation reporting starts on the date of incorporation, however, you might have transactions that relate to the sole proprietorship that overlap while you effect the transition. 

Ideally, you should close out the current accounting software for your sole proprietorship .  Make sure to export all relevant reports and data since inception of your business, before deprecating your account, including:

• Balance sheets by fiscal year

• Profit loss by fiscal year

• General ledger since inception

• Trial balance by fiscal year

• Accounts payable details

• Accounts receivable details

• Supplier, customer, employee lists

• Sales tax details

• Payroll details

Get an accountant

A corporation has greater complexity when it comes to tax reporting and preparation.  As such, it is a good idea to source an accountant as soon as possible to help guide you through your obligations and let you know what you need to do right at the beginning to ensure a smooth transition.

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Planning to incorporate your business?

• Streamline the process by downloading your free start your corporation checklist!

• Check out my book for in depth guidance on the regulatory, financial and tax aspects of starting your corporation.

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