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Should a software consulting services company incorporate?

Expert: Lloyd Lindsay

Andrew asked:

I am currently self-employed living in Ontario. I provide software consulting services to a company in U.S. and get paid in U.S. dollars.

I work mostly out of home with two to three visits to U.S. for a period of three to four days at any given time. At the end of calendar year the company issues a 1099 in my personal name. I have been allotted a GST/HST number by CRA. Should I set up a company and incorporate? Are there any advantages in incorporating? Can I set up a business and not incorporate? Any disadvantages?

Lloyd Lindsay answered:

Filing a Canadian-Ontario T1 Income Tax Return
Both Canada and the province of Ontario impose income tax on their residents. Because you are a resident of Ontario, you must report and pay income tax on your world income to both jurisdictions. However, Canada and Ontario do provide full or partial income tax credits for income taxes paid to foreign jurisdictions.

In determining your total income for Canadian income tax purposes, you must convert your US$ income to Canadian dollars. And to assist you, Canada Revenue Agency (CRA) has provided a schedule of conversion rates. You must be consistent when you convert your income and may pick one of three available options:

  1. Use the published 2010 annual average rate of 1.0299. You multiply this rate times the total U.S. dollars you received for the year. If you received US$10,000, you would report C$10,299 income in your Canadian/Ontario T1 Income Tax Return.
  2. Use the published 2010 monthly average rates. The month you received your income will determine the rate for that income.
  3. The last option is to use the actual C$ you received if you converted your U.S. income immediately after you received it.

GST/HST Issues
Software consulting services are taxable for GST/HST purposes. Generally, except for personal services such as a haircut or a restaurant meal, the GST/HST rate is determined by the address of your client. For addresses within Canada, the rate you charge depends on the Province: for Alberta it’s five per cent, for Ontario it’s 13 per cent, etc. For addresses outside Canada, the rate is zero per cent. However, you still may claim a refund for the GST/HST you pay on your business purchases.

U.S. Income Tax Returns
You mentioned that your client/employer issues you a 1099 in your personal name. Usually, this indicates that the company is treating you as a self-employed person and not an employee. If you are a U.S. citizen, you must file a U.S. income tax return and you should obtain advice from a tax professional specializing in dealing with U.S citizens working abroad.

If you are not a U.S. citizen, consult with the controller or accountant at your client/employer to learn how the company has treated others in similar circumstances and whether you may be required to file U.S. income tax returns. Residents in the same jurisdiction as your client, may have to file income tax returns to the U.S. Federal, State, City, and County governments. If you must file U.S. income tax returns, use a tax professional who is familiar with the tax laws for residents in that jurisdiction as well as with the Canada-U.S. Tax Treaty.

Should You Incorporate or Not?
Generally, an individual can operate a business such as software consulting without incorporating, and the business is called a proprietorship. However, for certain services, the government may require you to incorporate. Usually, you must register the proprietorship’s name in the jurisdiction where you are located. The advantages of using a proprietorship in the first few years are many:

  • Ease of starting or ending a business.
  • Low accounting and legal costs.
  • Business losses can be applied against your other personal earnings for income tax purposes.
  • You file only one income tax return.
  • Extracting more money than you put into the business does not give rise to income taxes.
  • Books and records may be kept on a less formal basis.

The main disadvantage is: UNLIMITED LIABILITY!

A corporation is an artificial person created by law. Because of this, you must deal with it with much more formality than a proprietorship. Here are some of the advantages of incorporation:

  • Limited liability; if the company goes under, your personal liability may be minimal if you have complied with the law.
  • Low rate of taxation; on the first $500,000 of income, the rates on active business income earned by a private corporation are generally less than those earned by an individual.
  • Allows for formal planning of distribution of income and passing ownership to children and/or employees.
  • Easier to do business in other jurisdictions.
  • Longevity; if the owner dies, the business continues.
  • Image; a corporation gives off a more business like appearance.

And here are the disadvantages:

  • Starting and ending the business are much more formal and will cost more.
  • Double taxation; when you take the money out, you are taxed a second time; however taxable Canadian dividends do provide a dividend tax credit to help relieve the burden of double taxation.
  • Higher accounting and legal costs.
  • Unable to apply early year losses against other income you earn personally.
  • You must keep more formal accounting books and records as well as a minute book.
  • You must file corporate income tax returns as well as your own personal income tax returns.
  • Extracting more money than you put into the business can give rise to income taxes.

Although I have covered only some of the advantages and disadvantages of incorporating, you should obtain independent legal advice with regards to your personal circumstances.

About the author

Lloyd Lindsay is a CA, a licensed Public Accountant, Chartered Professional Accountant, and a Certified Management Consultant. He completed the CICA In-Depth Tax Course in 1985 and has been in public practice for over 40 years. Also, from time to time, he teaches on a contract basis.

Lloyd is a member of the Personal Computer Club of Toronto and has hosted its Microsoft Office Special Interest Group for many years.

In addition to providing tax, accounting, and auditing services, Lloyd provides presentations on those topics and on using accounting software, PowerPoint, and MS Office programs.

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