You did it! You started, or you are starting, your own business. Good for you. The days of sticking it out at the same monster corporation for 30 years and ending with a cushy pension are over. There’s never been a better time to take charge of your own life and start a business doing something you really love!
In Canada, the three most widely used legal structures for a business are sole proprietorship, partnership, and corporation.
So which one are you? How do you know and how do you decide what’s best for you?
There are no set rules, but each form of ownership has advantages and disadvantages that affect you and your business. It’s important to examine these variables before you choose a particular structure for your new venture.
Oh, how easy it is to be a sole proprietor. Simply hang your sign and charge someone a fee: Poof! You’re in business.
A sole proprietorship is a business that is owned and operated by one individual – you. You are the boss and you have 100% control. You can run your business under a name other than your own for marketing and branding purposes without any sort of registration. You do have to register your business with the province if you want to use your branded name as your bank account name, collect/charge HST or hire employees. Though this costs money, registering a business is much cheaper than registering a corporation and maintaining it.
Easy start-up and low annual maintenance costs are the biggest advantages to choosing to be a sole proprietor.
Another big advantage is the simplicity of taxes. As a sole proprietor, business income is your income and must be declared on your personal tax forms. There is no need to file a separate tax form for your business. Additionally, business expenses and business losses can be used to reduce your overall personal income.
There are several disadvantages to sole proprietorship that should be taken into account, as well. The big one is personal liability. Because you are the big cheese, head honcho, all-seeing-all-knowing god of your business, you are on the hook for everything. You are personally responsible for all liabilities of the business. Should your business go bankrupt, your personal assets are up for grabs to repay those debts to creditors and lenders. Should your business be sued, you are personally on the hook to pay those fees too.
If you choose to run your business as a sole proprietor, ensure that you do not have an extremely risky venture with large liabilities, high overhead costs, or a high probability of lawsuits. If you do have these types of costs and risk, ensure that you are properly insured to handle them.
Like a sole proprietor, if you and some friends hang out a sign and sell something for a profit, poof! You’re officially in a partnership. This is very important to understand because you can bind yourself legally into a partnership without even realizing it. Once in, the government has default rules of engagement that direct your business regardless of whether or not you have a formal partnership agreement in place.
The government will see your business venture as a partnership if either of these conditions are met:
i. You and your partners own business assets together (property, inventory, capital etc.), or
ii. All parties share NET PROFITS (as opposed to gross revenue) of business transactions.
If this is you, congrats! You are in a general partnership. Without a partnership agreement, you are now governed under the default partnership rules of your province.
For the purposes of this article, I will examine the advantages and disadvantages of the default rules of general partnership without a partnership agreement.
A great advantage to being in a partnership versus a corporation is the low-key structure. There is no need for formal meetings, meeting minutes, elected officers, and the hassle of all the extra paperwork like a corporation. By default, each partner must share equally in the management and also share in the profits.
Additionally, with a partnership, there is tax simplicity. Each partner is responsible for claiming their share of partnership income and expenses on their own taxes. There is no need for a partnership to file a separate tax form, like a corporation would.
When profitable and well-functioning, the default partnership rules seem to be wonderful. However, without a partnership agreement there are some major downfalls that should be noted. Mainly, each partner shares equally in the debts of the company and can be obligated for the full amount for your personal assets. This is exacerbated because you are on the hook and bound by any business transactions your partners make. For example, if your partner signs for too much liability and has no assets to pay back the debt, you are on the hook for 100% of it even though you did not make that decision.
Another disadvantage to a partnership without a partnership agreement is the matter of winding things up. The default rules state that the only way to wind up the business is if the partnership goes bankrupt or if one of the partners gives notice. Under the default rules, if one partner walks out, all assets are liquidated and all debts repaid first and the rest is then split on a ratio scale for who put the most money into the partnership. There is some matter of proportional payout, but only after debts are repaid.
There are other options for partnerships. A limited partnership is a partnership where one partner contributes to the business without actually being involved in the management of the partnership. As a limited partner, you’re only on the hook to creditors up to the amount you personally invest in the firm.
To be considered a limited partner, you cannot take any part in the management of the firm or act on behalf of the company, otherwise, you become a general partner.
Limited Liability Partnership
People often ask me about limited liability partnerships. This is for groups of professionals, such as doctors, lawyers and accountants. There is specific provincial legislation for these and limits each partner’s liability to the choices they make.
Last is the corporation. The one major difference between a corporation versus sole proprietorship or partnership is that the corporation acts as a separate legal entity, whereas the legal liability of the business of a sole proprietor or partnership is the same as the partners or owner.
Because of this, no member of the company can be held legally responsible for debts or court orders of the company. This is one of the major advantages to incorporating - less personal risk. Additionally, there are favourable tax rates for small businesses and more flexibility is available for your personal salary. As a corporation, you can choose how and when you would like to pay yourself income so you have more control. Keep in mind, however, once you pay yourself a salary from the business, you and the corporation must pay CPP and income tax. This is often forgotten and can lead to big trouble with the CRA.
Many people believe that it is in their best interest to incorporate because of the above mentioned advantages, however, incorporating is expensive to arrange and even more so to maintain. Each year the company must submit its own tax forms, maintain meeting minutes, and more.
Business owners often hire professional accountants and lawyers to ensure that they are onside with corporate laws and taxes each year. This can be an expensive pain in the butt.
Finally, the liability may not be as limited as you think. Usually banks will require personal security in order to obtain business loans; therefore, the owner is still on the hook financially.
Which legal structure is most appropriate for your business is a difficult choice to make. If there is a high chance your company will be sued, or if you have large overhead costs and payrolls, a corporation is likely an appropriate choice. If you have low overhead costs and low legal risks, you may want to consider sole proprietorship or partnership for ease and low maintenance costs.
Ownership is an adventure. The legalities can seem daunting, but once you make your choice, the exciting part begins!
Shannon Simmons is a financial advisor and founder of The Barter Babes Project. She offers professional financial advice to those who can't usually access it by providing her financial services in exchange for a bartered good or service instead of a fee.