A Primer on Business Structures
Starting a business in Canada is an exciting venture. The Canadian economy is built on small businesses, and the pandemic has shown how quickly small businesses can grow and adapt to fill niches in a demanding market.
When starting your own business, you likely already understand your future industry, and may have an idea of the marketplace, how you plan on promoting your services, and even how you will set your prices. However, deciding on how best to arrange your financial and legal affairs might be significantly more complicated and unfamiliar.
A corporate lawyer will help you set up your business legally in a structure that’s right for you, and one that ensures you’re well-positioned for future growth. We understand that business structures can be confusing as clients sometimes come to us with one idea in mind when an entirely different setup would better suit their business. Each business needs to be assessed differently. Below is an overview addressing some of the most common questions that arise about the various business structures available.
What is a sole proprietorship?
A sole proprietorship is where the business owner is the only owner of the business. Sole proprietorships can operate under the owner’s name, or a separate name that you have chosen. Aside from the registration of a business name, there may be little formal legal setup to a sole proprietorship.
The benefits of a sole proprietorship are mostly based on the degree of control that the proprietor has over the business. As the sole proprietor, you have full ownership and control over the decisions affecting the business, and how you decide to grow. The taxes on any income earned by the business are paid personally by the sole proprietor, and a financial professional can assist in calculating business losses or expenses that may be deducted from that income.
The drawback to a sole proprietorship is, with such a high degree of control, there also comes personal liability. Sole proprietors are not distinct from their business. As a sole proprietor, creditors can claim against your personal assets to pay off the debts and any litigation against the business is treated as litigation against you. Also, sole proprietorships are difficult to scale, and it can be complicated to create a succession plan or sell the business if the goodwill is tied to one person.
What is a partnership?
Much like a sole proprietorship, a partnership also does not require a formal legal setup – it occurs whenever two or more persons are “carrying on business in common with a view to a profit”. This definition means that a partnership can occur organically and, in some situations, unintentionally. Sometimes a partnership is seen to exist even if the partners themselves do not want one to. Therefore, it is very important to have a partnership agreement in place or consult a lawyer to ensure that a partnership is not deemed to exist.
A partnership agreement spells out the structure of the business, including the rights and responsibilities of each partner, and generally will displace the terms that are deemed to apply by virtue of the Partnerships Act, R.S.O. 1990, c. P.5. Three types of partnerships exist in Canada. In a general partnership, each partner is jointly and severally liable for the debts of the partnership. A limited partnership allows some partners to take a back seat, where they can invest within the partnership but are only liable for the amount of their investment. Lastly, some professional designations (like lawyers) are allowed to form a limited liability partnership, however, these are rare and tightly controlled by each province.
There are numerous advantages to setting up a partnership. Like sole proprietorships, the legal formalities may be simpler. Partnerships can start with minimal start-up expenses and have fewer reporting requirements than a corporation. Partners may also treat their partnership income as personal income and can deduct any losses from the business against their personal income. It can also be the opportunity for owners with different talents and experience to work together on equal footing and start something new.
The best part of partnerships is that they can function much like a marriage. The worst part of partnerships is that they break up much like a marriage. If there is not a partnership agreement that specifically ousts the Partnership Act, the result of a dissolution may be contrary to the expectations of the parties – possibly drastically so. A well-written partnership agreement should, at minimum, account for what happens when one partner wants out of the agreement, dies or becomes incapacitated, how the partnership property is dealt with upon dissolution, and what level of mutual agency the partners have vis-à-vis each other. Having a written partnership agreement can prevent a lot of conflict, stress and volatility when a partnership ends.
What is a corporation?
Unlike a sole proprietorship or a partnership, an incorporated company is a separate legal entity that is distinct from its owners and is (in a legal sense) a “person”. Incorporating means that the company is not necessarily owned by those who work in the business but is instead owned by the shareholders of the corporation. People are then appointed as officers and directors of the corporation to oversee and run the business of the corporation. In many small businesses, the incorporators, the directors/officers, and the shareholders are the same people but in larger corporations these roles may be, and often are held by, different people.
Why should a business incorporate?
One of the primary reasons business owners move to incorporate their business is for tax purposes. While sole proprietorships or partnerships pay taxes on their business earnings as personal income, in a corporation the business itself keeps the profits. Owners can arrange to pay themselves a regular salary, or dividends from the corporation, but will often do so in a way that is tax favourable. Money that is left in the corporation is taxed at the corporate tax rate, which is often significantly lower than personal tax rates, and so the business income will be subject to less taxes overall.
The other notable benefit to incorporation is that there is less personal liability for those involved in the business. In a sole proprietorship or partnership, the proprietors/partners may be named personally in a lawsuit and subsequently found personally liable for any of the financial losses, debts, and damages incurred on account the business operations. In a corporation, however, individual shareholders (i.e., the owners of the business) are not personally liable for the debts or obligations of the business. This level of protection is often what lets business owners sleep soundly at night.
What do business owners need to know before they incorporate?
While there are tax benefits to forming a corporation, there are also obligations. Corporations are required under provincial and federal law to keep detailed records of their finances and of their structure year to year. These records may be fairly straightforward in a small corporation with few people involved but can become more complicated as the business grows. Retaining the right professionals in both legal and accounting will help ensure that a corporation is meeting all of its legal obligations.
Lastly, business owners should always call a lawyer before taking that next step to incorporation. While forms may be available online, business lawyers are corporate experts, and will quickly recognize obligations and strategies that an unknowing business owner might miss. Retaining the right legal counsel early can be tremendously helpful in preventing problems before they start.
Our team of business lawyers works with all sizes of businesses in the Cambridge, Kitchener, and Waterloo region. We are your trusted advisors from day one and can help you navigate through issues as your business grows. Contact us today to learn more about how we can help your business set up a solid legal foundation.