Incorporation, Partnership, Proprietorship - Selecting The Right Structure For Your Business

One of the questions that business owners may ask at any time is “should I incorporate my business?” The legal structure of your business is an important consideration and the selection of an appropriate structure can help plan for the future growth of your business. It should be said straight away that tax considerations should not necessarily be the only reason for deciding to incorporate your business.

Following is a discussion of the three main types of business structure and the advantages and disadvantages of each form.

Three Structures of a Business

There are three main forms of business structure available in Canada: Proprietorship, partnership, and the corporation.

Proprietorship

The sole proprietorship is the simplest and easiest form of business structure. There is no separation of the owner and the business. Business income is taxed in the hands of the owner and is included on the personal tax return of the owner.

The sole proprietorship is a simple form of business because it can be quickly set-up. In some provinces you may need to register your business name and obtain a business license from your city or municipality.

The sole proprietorship is not a permanent entity. If the owner passes away, the assets are passed to family but any debts may not be transferred.

The owner of the business is fully liable for all debts and actions of the business. If the business becomes insolvent or if the business is sued, the personal wealth of the owner is at risk.

If your business is operating at a profit, it is possible that your tax bill may be higher depending on the level of business income earned.

Partnership

A partnership is very similar to the sole proprietorship structure. The only difference is more than one owner and percentage of net partnership income earned is included proportionally on each of the partners’ personal tax returns. Similarly, losses incurred by the partnership are allocated proportionally to the partners.

When going into business as a partnership, it is advisable to draw up a partnership agreement stating what happens if the partnership is dissolved and how disputes will be handled. Without a partnership agreement some provincial laws establish certain terms for partnerships. However, if certain conditions are not covered by law can cause problems in the event there is a dispute.

Like a proprietorship there is a risk of unlimited liability with one exception: Limited partnerships. Limited partnerships permit the partnership to bring in new limited partners, however the limited partners must not be involved in the management of the partnership to ensure they are insulated should the firm be sued of become insolvent. In the limited partnership structure, the general or principal partners have unlimited liability like the sole proprietor.

Each partner brings skills and experience to the business to benefit all of the partners. On the other hand, decision making in a partnership is made jointly.

Incorporation

The corporation is established through the drafting of the articles of incorporation and registering the firm with the federal or provincial government. This process can be costly to establish and imposes administrative requirements on the owners.

The corporation issues shares to its shareholders to raise funds to begin operations and it can pay dividends to its shareholders or a salary to its owners. The issuance of shares provides a mechanism to obtain funding to establish or expand a business by offering a portion of the business of a range of investors without imposing repayment terms on the corporation (there is no requirement to pay dividends on common shares issued). Losses incurred by the corporation are retained and cannot be deducted from the owners’ income until the shares are sold.

The corporation is considered a separate legal entity separate from its owners which insulates the owners of the business from legal liability, hence the term limited liability company (or Ltd.). If the business is well established and has lots of assets for collateral, then the liability of the shareholders is their investment in the business. However, many financial institutions may ask for personal guarantees for the corporations’ debts and thus overriding the limitation of liability. Similarly, the directors of the corporation are liable for remitting source deductions and GST. On the other hand, if the business is engaged in work that has potential civil legal implications (i.e. it could get sued), then the owners personal assets are protected.

The corporation pays its own tax. The corporate tax rate on privately held Canadian controlled corporations (CCPC) has a very low rate of tax on the initial $400,000 (as of 2007). The income will be eventually taxed when it is paid to its shareholders and thus the advantage of the lower tax amounts to a deferral. Keep in mind that the lower tax rate applies only to income from business activities and does not include investment or rental income. A corporation set-up to hold investments does not qualify for the lower rate of tax and may not provide any advantage from a tax perspective.

The corporation clearly separates the owners and the managers. In smaller firms there is a mix of personal and business affairs which can complicate your tax situation. In addition, if you cannot leave profits in the corporation, then any tax advantage is reduced or eliminated. Again the tax advantage amounts to a deferral since the tax paid by the corporation and the individual is essentially the same.

The owners of the corporation may be exempt from tax on the first $750,000 (from March 18, 2007 forward) of capital gains incurred on the sale of the shares of a Canadian controlled private corporation (CCPC). Every Canadian has access to a lifetime capital gain exemption of $750,000 on the capital gains incurred on the sale of the shares of a CCPC. On the other hand losses can be written off against the income of the shareholders.

The corporate structure can be complex and may not provide a tax advantage to the owners. Incorporation is best when a business is profitable, there is and intend to pass the business on to other family members, or there is a liability concern.

If you are considering incorporation, seek professional advice.