What Type of Business Structure is Right for You? Sole Proprietorship vs Partnership vs Corporation
There are several different types of business structures that exist, which you should keep in mind when setting up your business. You have several options: you may operate as a sole proprietorship, a partnership (a general partnership, limited liability partnership, or limited partnership), or a corporation. In this article, we will give you a brief overview of each type of business structure, as well as the advantages and disadvantages of incorporating.
SOLE PROPRIETORSHIP:
A sole proprietorship is an unincorporated business that is owned by one single individual. It is the simplest kind of business structure, where the owner has responsibility for all decision making, receives all profits, and claims all losses. The owner of the business personally has no separate legal status from the business, which means that creditors can come after the owner’s personal assets as a way to satisfy debts owed by the business. In other words, the risks of the business extends to the owner personally.
The owner of a sole proprietorship pays personal income tax on the net income generated by the business. As the owner, you may either register a business name or operate under your own name. This type of business structure is often popular with sole owners of businesses, individual self-contractors, and consultants. It is very easy to set up (the sole proprietorship begins the moment you begin conducting business) and does not require much maintenance.
PARTNERSHIP:
Legally, a partnership is formed whenever two or more persons carry on business with a view to profit. There are three main categories of partnerships: general partnerships, limited liability partnerships, and limited partnerships.
General Partnership:
A general partnership is relatively easy to establish between 2 or more partners. There are no formal legal requirements. It is more complex than a sole proprietorship and less so than incorporation. You would need a registered trade name, a registered tax number for applicable taxes, and a bank account. The owners of a general partnership pool their funds in order to raise capital. Public reporting isn’t required, but general purpose financial information may be needed to satisfy the bank, vendors, and tax collectors. In terms of taxation, each partner is taxed personally on his or her share of the partnership income (making a tax return for the general partnership itself unnecessary). Importantly, each partner is liable for all the assets and liabilities of the partnership. If the company is sued, each partner’s personal assets can be seized to settle the claims. In other words, partners have unlimited liability (unlike a corporation, where creditors can only look to the assets of the business and not the owners personally to satisfy the debt).
Often, the partnership is memorialized in a partnership agreement (usually written, although oral agreements are legally valid as well). In many cases, partners will agree to proceed with major decisions only if there is unanimous consensus, or majority consensus. An agreement is important since all partners have unlimited liability, meaning partners can be on the hook for the inappropriate or illegal actions of the other partners.
General partnerships dissolve when one partner leaves the partnership. However, provisions can be added into the partnership agreement for this contingency – for example, if one partner dies, their interest may be transferred to the surviving partners, or alternatively, a successor.
Limited Liability Partnership (LLP):
An LLP allows firms to retain their partnership structure while protecting the personal assets of partners who have no involvement in a negligence action. The firm is liable for the acts committed by its members in the ordinary course of the business of the firm, but individual members are not liable for each other’s acts. They must, however, continue to maintain responsibility for their own acts and for those they have a supervisory role over. In a limited liability partnership, each partner’s liability is limited to the amount of capital they invest into the business. Partners in a limited liability partnership are generally liable for all business obligations of the business, but are not liable for the other partner’s tortious (i.e. negligent) acts. A limited liability partnership is somewhat of a hybrid structure: somewhere between a corporation and a partnership. Like a corporation, an LLP is a corporate body and therefore a separate legal entity and partners’ liability is limited. However, like a partnership, the relationship between the partners is governed by a private agreement.
Limited Partnership (LP):
In a limited partnership, there are what we call “general” and “limited” partners. The general partner is liable for all the debts and obligations of the partnership and is in charge of the daily management of the business. The role that a general partner plays is similar to any partner in a general partnership. A limited partner (also known as silent partners), on the other hand, has limited liability. In other words, their liability is limited to their investment into the business. Importantly, limited partners cannot take part in the management of the business (though they can contribute capital). If the limited partner is listed as a limited partner on paper, yet in substance helps to manage the business, then they will be deemed to be a general partner, and their limited liability status ends.
CORPORATION:
A corporation is a distinct legal entity that is separate from its owners. A corporation operates and has the same rights, under law, as a legal person (meaning me or you) – which means that it can enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets, pay taxes, etc. We’ve included some of the benefits and drawbacks of incorporating your business below.
There are many advantages to incorporating, including limited liability, lower tax rates, perpetual existence (which has impacts on succession planning), and may give you easier access to capital.
ADVANTAGES:
Limited Liability:
Unlike a sole proprietorship, where the owner must assume all the risks of the business (which puts even the owner’s personal property and assets at risk from business creditors), the owners of a corporation (these are shareholders – the amount of shares each shareholder holds in the company represents their percentage ownership in that business) have limited liability. This means that the losses that the owners of the corporation may incur is limited to the amount of capital they invested in the business. Creditors cannot go after your personal assets or property to recover debts of the business. (That would be like recovering money from person A to satisfy the debts of person B – remember, a corporation is its own legal entity, or person!)
Lower Tax Rates:
If you are operating as a sole proprietor, you would pay personal income tax on the net income generated by your business. In Canada, corporate tax rates for small business can be quite low when compared to personal tax rates. Incorporating provides the opportunity to save or defer taxes. For example, the Small Business Deduction may apply if your company qualifies as a Canadian-Controlled Private Corporation (CCPC). (Some of the requirements to qualify as a CCPC include: being a private corporation; having either been incorporated in Canada or residency in Canada; and that it is controlled by a person who is a resident of Canada.) The Small Business Deduction applies to the first $500,000 that your company makes each year. Additionally, your shares may qualify for a Lifetime Capital Gains Exemption if they are deemed to be qualified small business corporation shares. This can reduce the amount of taxes you pay when you leave the business.
Perpetual Existence:
A corporation, unlike a sole proprietorship, lasts forever and continues to exist even after the death of its owner(s). This stability allows you to plan over a long-term, provides flexibility when transferring assets to others, and allows you to leave your legacy into the future.
Easier Access to Capital:
Raising capital is generally easier for a corporation, as corporations can issue shares of stock. This is a way for corporations to raise money from investors who invest in the company and become shareholders. In exchange for their investment, shareholders may have a stake in the company’s equity as well as a share in its profits in the form of dividends – depending on the types of shares they possess. Additionally, often banks will be more willing to lend money to a corporation as opposed to an unincorporated business.
DISADVANTAGES:
Some of the disadvantages of incorporating include increased expenses and administrative work, and the more complex process of closing a corporation.
Increased Expenses:
One downside of incorporating is the expenses that come with it. By nature, corporations are more complex than other types of structures – some of the fees that are required include incorporation fees (such as a NUANS name search report, and the government application fee when you incorporate), or any additional accounting fees, depending on how complex your finances are. You will have to file two separate tax returns each year – one for your personal income and one for the corporation.
Increased Administrative Work:
The government requires corporations to keep an up-to-date Minute Book, and to keep them updated on any changes, such as directors lists or registered address. They also require that you update certain corporate records.
Closing a Corporation is more Complex:
To close your corporation, you must pass a corporate resolution (which is a written document created by the Board of Directors detailing a binding corporate action) to dissolve the corporation, wind up payroll accounts, and send a copy of the certificate of dissolution to your provincial authorities (or the CRA).
THE BOTTOM LINE:
As you can see, there are a variety of different business structures which you can opt for when starting your business. The decision is personal and based on your own business needs. Your business’s legal structure determines your tax rates, management/paperwork requirements, and more. There are pros and cons to each – for example, sole proprietorships and partnerships are relatively easy to start but lack liability protection. Corporations may take more work to start but offer liability protection and potentially more favourable tax rates. We offer free 30-minute consultations here at Ordower Law: please feel free to schedule a call with one of our team using this link.
For more general information on incorporating in Ontario or starting a business in Ontario, please view our guide here: Incorporate in Ontario and Canada- Everything You Need to Know.
