Section Two: Factors in Selecting your Business Structure
Not all legal arrangements are available in all situations. If there is only one owner of a commercial activity, the choice is between a sole proprietorship or a corporation. If there is more than one owner, the choice is between a partnership, limited partnership, and a corporation.
Provincial legislation requires that some individuals may only carry on as a partnership (medicine, law, chartered accounting).
Corporations are the only business structure that protects owners’ personal assets. If you wish to protect your personal assets in the case of financial failure or legal suits, corporations are the preferred structure.
If the business may be exposed to a substantial uninsurable risk, a corporation is the preferred entity.
In some cases, even though insurance is available, incorporation may be a less expensive alternative.
Flexibility and Administration of Structure
Corporations require separate annual tax returns, company by-laws, resolutions and formal meetings and minutes to make changes to the bylaws and resolutions. Although sole proprietorships and partnerships must pay taxes, the returns are done along with the business owner’s annual personal return. Therefore, the administration associated with operating a corporation is much more expensive and complex.
While the Partnership Act provides for the various rules for the partnership structure, many of these rules may be changed by agreement between the partners.
In contrast, many of the rules governing the relationship between shareholders are mandatory.
In some cases, it may be desirable to form a partnership rather than incorporate a limited company.
Operating as a sole proprietorship is the most flexible and easiest to administer form of business ownership. One person is responsible for all the decisions of the company without having to consult corporate by-laws or other rules and regulations. Taxes are paid when the owner files their personal income tax return.
Income Tax Requirements
The income from sole proprietorships and partnerships affect the owners’ personal income and is taxed at personal income tax rate. Corporations, as distinct legal entities, pay corporate tax on profits. Net profits earned by a corporation after tax is then distributed to the shareholders as dividends which is taxed in the hands of the individual shareholder. Tax laws treat these business structures differently and an accountant should be consulted to determine the tax “costs” of each structure.
Partnership income is distributed to the partners and is taxed in the hands of the partners. Losses incurred by a sole proprietorship or a partnership can be offset against other income earned by the sole proprietor or the partners in the partnership.
Losses earned by a corporation do not flow through to a shareholder and a shareholder may not use the losses incurred by the corporation to offset against other income earned by the shareholder.
An owner/manager salary paid by a corporation is an expense to the corporation and no tax is paid on this amount. However, the owner/manager includes the whole amount of the salary as income and is taxed on this amount.
In addition, qualifying shares in a Canadian controlled private corporation may be eligible for a super capital gains exemption. Business operators should check with their accountant or Revenue Canada to see if they qualify for these exemptions.
1. Sole Proprietorship
Sole proprietorships may register their business name with the Provincial government. They are only required to register their name if they operate under a name different than that of the owner.
Registering a business name does not legally protect the use of this business name for the business owner although it does show proof of prior registration in the case of a dispute with another business using the same name.
Usually, sole proprietors may register their business name for less than $100 with their respective Provincial government including a search on the name to determine if it is used by other sole proprietorships.
All partnerships should be registered with the appropriate Provincial office — the cost should be similar to that of a sole proprietorship — less than $100. In addition, it is advisable that the partners have a lawyer draft a partnership agreement to determine the rights and obligations of the partners in partnership. The legal cost of drawing a partnership agreement starts at approximately $250.00 depending on the number of partners and the complexity of the agreement. You can save money by drafting your terms before visiting a lawyer so you are prepared and lessen the time required by a lawyer.
The cost of incorporating a limited corporation for an owner/manager is approximately $1,000.00 including disbursement costs from the legal firm.
If there is more than one shareholder, it is advisable that a shareholders agreement be drafted and signed by the shareholders. The legal cost of completing a shareholders agreement between two individuals starts at $250.00 depending on the complexity.
In addition, a corporation must file a corporate tax return and have an annual meeting of the shareholders and directors. The cost of preparing annual minutes or corporate resolutions is approximately $250.00 per year. Preparation of a corporate tax return by an accountant is approximately $200.00 and up.
In many circumstances, the legal/accounting costs for the creation and maintenance of the corporation often exceeds the legal and accounting costs of creating and maintaining a partnership or sole proprietorship.
Length of Business Life
If the registration of a sole proprietorship or partnership is not renewed, it expires five years after registration. However, corporations have an infinite life unless it is legally dissolved.
Borrowing Requirements and Attracting Investors
Normally, it’s easier to raise money from private lenders where shares in a corporation are marketed as opposed to the sale of units in a partnership or limited partnership.
Sole proprietorships are owned by one person and, therefore, no other person can invest in the business. Partnership may raise extra money by investors becoming limited partners. As limited partners, these individuals do not participate in decision making or running of the business but invest money in return for a percentage of the profits.
Corporations provide the best structure to attract investors through the sale of shares. These shares offer investors the chance to earn returns through dividends or the shares raising in value. However, the ability of businesses to raise money through selling shares depends on how the company is viewed by potential investors.
Sole proprietorships and partnerships cannot use the words incorporated, limited or their abbreviations such as Inc. or Ltd. Depending on your business activity, suppliers, customers and others may judge the stability and credibility of business, in part, on its structure. Corporations are sometimes perceived as being more stable and secure.
Click on Worksheet 3.1 (Word Document) to determine the best business structure for your enterprise.