Canada: Blog: New Business Tool Kit Chapter 1 – Selecting A Legal Entity

One of the first major decisions to be made when starting a new business is determining the type of business structure it will take on. Simply put, a business structure is how you will own and operate the business. Before starting you must determine the structure your business will take on and ask yourself whether you wish to work by yourself as a sole proprietor, together with another person or persons in a partnership, or as an incorporated company. It is important for you to determine the structure of your business before you start, as each of these three structures have unique advantages and disadvantages, especially in regards to legal and tax matters.

SOLE PROPRIETORSHIP

A sole proprietorship is typically the easiest type of business to set up because you only need to register your business name provincially, that is unless you decide to operate under your own name. As a sole proprietorship you do not typically have any rules or operating regulations which you must follow to function. Typically the business decisions are solely the result of your abilities.

Operating as a sole proprietorship means that your business will not be recognized as a separate legal entity, but rather as an extension of yourself. This means that you, as an individual, will be fully responsible for all debts and obligations related to your business. This is known as unlimited liability and gives creditors a right to make claims against all of your assets, including personal property. Unlimited liability also extends to income taxes, as such all your business income and expenses will be reported on your personal tax return.

Operating as a sole proprietorship, you are the business. This is both advantageous and disadvantageous for some of the following reasons:

ADVANTAGES

  • Low start-up costs
  • Greatest freedom from regulation
  • You have direct control of decision making
  • Minimal working capital required
  • Possible tax advantage
  • All profits go to the owner automatically

DISADVANTAGES

  • Unlimited personal liability
  • Difficult to raise money
  • Income taxable at personal rates
  • Lack of continuity in your absence

PARTNERSHIP

A partnership is an alternative business structure that can be beneficial to you if you want to carry on business with a partner without having to incorporate your business. In a partnership you and other like-minded individuals can pool your collective resources to form a business. With this in mind, there are two type of partnerships; general and limited liability.

In a general partnership, each individual has the ability to exercise authority in addition to having a share of the company's assets and liabilities. Essentially, each partner is responsible for the actions and consequences of the other partner(s).

In a limited partnership, some partners control and manage the business while others limit their involvement and simply serve to provide capital. As a limited partner takes no part in the control or management of the business, their liability is limited to their investment.

In either case, before you enter into a partnership it is recommended that you draw up a detailed legal agreement to establish the terms of your business and type of partnership, so that you can be protected in case of a disagreement or dissolution.

A partnership is a legal entity recognized under the law and as such it has rights and responsibilities in and of itself. A partnership can sign contracts, obtain trade credit and borrow money. However a partnership is similar to a sole proprietorship in a few regards. Much like a sole proprietorship, each partner's share of income is combined with their personal income and may need to be reported through a Partnership Information Return.

Operating as a partnership is both advantageous and disadvantageous for some of the following reasons:

ADVANTAGES

  • Low start-up costs
  • Additional sources of investment capital
  • Possible tax advantages
  • Limited regulation
  • Broader management base
  • Partnership incentives for employees

DISADVANTAGES

  • Unlimited liability
  • Held responsible for partners’ actions
  • Dividend authority
  • Difficulty raising additional capital
  • Hard to find suitable partners
  • Possible conflict between partners

CORPORATION

A third option is incorporation whereby you form a corporation. A corporation is a separate legal entity that exists under the authority granted by provincial or federal law. By incorporating, you and others own shares dispersed by your corporation. A corporation has all the legal rights of an individual and is responsible for its own debts. It must also file income tax returns and pay taxes on income it derives from its operations. Typically, the owners or shareholders of a corporation are protected from the liabilities of the business; however, when a corporation is small, creditors often require personal guarantees of the principal owners before extending credit. The legal protection afforded to the owners of a corporation can outweigh the additional expense of starting and administering a corporation.

A corporation must obtain permission from provincial or federal authorities to use or do business under a registered name. A corporation must also adopt and file Articles of Incorporation and By-laws, which govern its rights and obligations to its shareholders, directors and officers.

Corporations must file annual federal income tax returns and, in some provinces, provincial tax returns.

Incorporating a business allows a number of other advantages such as the ease of bringing in additional capital through the sale of equity, or allowing individuals to sell or transfer their interest in the business. It also provides for business continuity when the original owners choose to retire or sell their interest.

Should you decide to incorporate your business venture, you should seek the advice of competent legal counsel and accountants.

Operating as a corporation is both advantageous and disadvantageous for some of the following reasons:

ADVANTAGES

  • Limited liability
  • Ability to generate capital
  • Corporate tax treatment
  • Attractive to potential employees
  • Transferable ownership
  • Continuous existence

DISADVANTAGES

  • Closely regulated
  • More expensive than alternatives
  • Possible conflict between shareholders and directors
  • Possible problem with residency of directors
  • Extensive corporate records required

WHICH STRUCTURE SHOULD YOU USE?

Your professional advisors can help you work through the advantages and disadvantages depending on your personal situation, but ultimately it is your decision

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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