When you are self-employed, there always comes a time when you wonder whether you should incorporate or not. Because while there are benefits, it also comes with a price to pay.
The situation
Raynald*, 52, is an employee two days a week in the Quebec public sector. He has a retirement fund and plans to retire at age 58 without penalty. For the other three days of the week, he is self-employed in the training field. “I want to continue this work for several years, but at a more pleasant pace starting at age 58,” he says. Since he earns about $90,000 as a self-employed worker, he plans to reduce this amount to $50,000 once he retires.
Raynald wonders if it would be in his best interest to create a business for his self-employment portion. “I am developing a project that I think will be lucrative,” he says. “I plan to leave at least $20,000 per year in my company, then sell it in about fifteen years. I don’t really know much about selling a business, but I estimate that it could be worth $150,000. Do you think this is my best option?”
The financial portrait
Raynald
- Annual salary: $45,000
- Annual income as a self-employed worker: $90,000
- Quebec government retirement fund: approximately $50,000 upon retirement, and his spouse as well
- Annual family cost of living: $93,000
- Estimated cost of living in retirement: $90,000
- Registered Retirement Savings Plan (RRSP): $164,000 for the individual portion and $292,000 for the couple, maximized
- Registered Education Savings Plan (RESP): $173,000, maxed out for all three children
- Tax-Free Savings Account (TFSA): $78,000, not maxed out for the couple
- Mortgage for the couple: $50,000 for a house worth about $700,000
- Car loan for the couple: $45,000
Advice
First, Léa Saadé, financial planner and regional vice-president, wealth management, at Financière des professionnels, would like to congratulate Raynald for the sound management of his personal finances.
“He is conscientious, he has maximized his children’s RESPs and his RRSPs, he makes good decisions and it is also good to ask the question regarding incorporation,” she says.
Although the need to incorporate is always assessed on a case-by-case basis, there are still points that apply to everyone, both in terms of advantages and disadvantages.
The Advantages and Disadvantages of Incorporation
“It’s certain that when you incorporate, it gives a more professional image,” says Léa Saadé. “Then, there’s the issue of protection. If the company is active in a field where there is a high risk of prosecution, it’s important to incorporate in order to separate your personal finances from those of your company. That way, if something happens, you don’t put all your assets at risk. In Raynald’s case, training is not a risky field.”
You should know that there are fees to pay to incorporate. There are also accounting fees that come back every year and they are higher than those of the self-employed worker who only has to do his income tax return. “An incorporated company must also do a lot of reporting to the government,” says the financial planner. “It’s more administratively burdensome.”
To compensate, incorporating allows you to keep money in your business tax-free and invest it in non-registered investments. When you take this money out, you benefit from a combined tax rate of about 20.5% for the first $500,000 generated by the business. For his part, Raynald expects a self-employed income of $50,000 and with his retirement fund income of $50,000, that would give him about $100,000 per year. Therefore, his marginal tax rate would be 36.12%.
The big question to ask is: will the business generate enough profits that can be left in the business to make incorporation worthwhile despite the associated costs?
“With the data provided by Raynald, the result is very clear: it would cost him more to incorporate,” says Léa Saadé. “You have to be able to leave a net savings of around $70,000 each year for at least 10 or 15 years in your business for it to be worth it from a financial point of view. Of course, he should reassess the situation annually with his accountant based on the growth of his business.”
Relying on the TFSA
Léa Saadé instead advises him to continue to maximize his RRSPs and his TFSA, in which he still has plenty of space.
“The TFSA has an interesting tax advantage, and it’s perfect for his needs because he won’t have a huge surplus of cash in his business,” she explains. “He’s launching it mainly to have a supplemental income for retirement.”
She is not worried about her savings to support her cost of living in retirement. “He will have enough money, even if he does not end up selling his business.”
Protect the whole family
The financial planner, however, draws Raynald’s attention to the importance of protecting himself since he is not married. “Does he have a cohabitation contract with his partner? If not, it would be important to make one in order to agree on the division of the family assets and what would happen to his business in the event of a separation. It’s something that should be done when everything is going well.”
He also has to make a will. “That’s true for everyone, but it’s even more pressing when you’re not married,” says Léa Saadé. “He has to think about his partner and his children. It’s very important that he do it and then he can have peace of mind because his whole family will be well protected if something ever happens.”
* Although the case highlighted in this section is real, the first name used is fictitious.