A major consideration when establishing or managing a small business is choosing which legal structure to operate your business under. There are basically three main choices; Sole Proprietorship, Partnership, and Incorporation. These are quite distinct structures with particular advantages and disadvantages depending on the situation. Here is a brief overview:
This is by far the simplest legal structure to adopt and is often chosen by individuals who are just starting out in business. Legally, and from a tax perspective, the business is not separate from the individual. A Sole Proprietor does not file a separate tax return for the business but rather includes any business activities in their own regular return. The pros and cons of this structure are:
A Partnership exists where two or more people engage in a profit seeking enterprise. A Partnership is an interesting arrangement where the Partnership itself is viewed as a separate entity on a certain level but each Partner has a legal and fiduciary responsibility to the other Partner(s). Partnerships are often established where two or more people combine their resources and skills to achieve a common goal. A Partnership can be established simply by the concerted actions of two or more individuals but, it is highly recommended to draft and institute a formal Partnership Agreement that details issues such as amount of time or resources contributed, responsibilities, how profits (losses) are shared, and admittance of new partners. From a tax perspective, annual income or losses are determined at the partnership level and then allocated to the Partners according to the Partnership Arrangement. The pros and cons of this structure are:
A Corporation is a distinct legal entity that has a legal existence and files tax returns separate and apart from the actual owners of the business. A Corporation is established under either provincial or federal legislation. The owner or owners of a Corporation are shareholders. While you are certainly familiar with ‘Public’ corporations whose shares trade on a stock exchange, the great majority of Corporations are “Private’ and owned by one or a few shareholders. As a separate legal entity a Corporation must be registered under the appropriate provincial or federal legislation. Depending on the particular situation, there can be material tax advantage by operating under a corporate structure, a key reason why this arrangement is often chosen. The pros and cons of Incorporation are:
Limited Liability of shareholders – as a separate legal entity, a Corporation can be sued and the shareholders are only liable to the extent of their investment in the Corporation so that their personal assets are not at risk.
Important Note – It is important to appreciate that although corporate law extends limited liability to shareholders, potential creditors of corporations (particularly new and/or small corporations) will typically require personal guarantees from shareholders before extending credit.
This is a question that can only be properly answered after reviewing and analyzing a particular situation, but a few rules of thumb can be offered:
This typically makes sense when a person is starting out in business, does not need a lot of capital and wants to keep establishment costs low. As well, any expected losses while the company becomes established can be assumed by the owner/manager personally for tax purposes.
If two or several like-minded people have a business goal and can agree on the relative contributions, this may be appropriate. Any expected losses of the partnership can be assumed personally by the Partners. Unlimited liability will exist but in many jurisdictions; the ‘Limited Liability Partnership’ for professionals such as lawyers and doctors will serve to reduce this.
Generally when a company has become established and expects to be able to generate profits and secure financing, the tax advantages and limited liability of Incorporation are very attractive.