Choosing a business structure is one of the most important decisions you will make as an entrepreneur. After you have developed your product or service, prepared the projections necessary to see if it will succeed in the marketplace, and checked zoning bylaws to ensure that the planned operation of your business will not contravene any municipal regulations, you must decide what kind of business structure is required to carry out the day-to-day activities.
This decision can have major consequences on your protection under the law on the way income tax rules will affect you!
There are three basic legal business structures: sole proprietorships, partnerships and corporations. In addition you may register as a society/not-for-profit or a cooperative.
A sole proprietorship typically is a business operated by an individual. It is the simplest form of business structure, but this by itself does not mean it is best for a given situation. One person performs all of the functions required for the successful operation of the business.
The proprietor owns the business assets and is personally liable for any debts incurred by the business.
Any profits or losses from the business are combined with other income of the individual, and reported on the personal income tax return for the calendar year in which the fiscal year of the proprietorship ends.
Sole Proprietorship Advantages
- Costs of incorporation are saved until later (if ever).
- Easy to change your mind later since you are the only shareholder.
- Expenses can often be claimed against other personal income – very useful for home based businesses run by people who are also salaried employees.
- No need for annual reporting to government.
Sole Proprietorship Disadvantages
- You can personally be held responsible for all debts and other liabilities.
- Banks, suppliers and others are less willing to lend you money or extend credit.
- Some government programs are only available to registered corporations.
- You cannot claim employment insurance benefits if the business fails.
A general partnership is formed by two or more individuals who together carry on a business for profit. There are three basic steps to the formation of a partnership:
- A registration of the partnership where required under provincial law.
- The creation of a partnership agreement.
- The transfer of capital from the individuals to the partnership.
The registration of a partnership name will allow you to pursue matters in court, if required. This could be important if there is a contract in the partnership name that you are trying to have enforced under law. Under the Partnership Act you must register your unincorporated business with the Registrar of Companies if you:
- are associated in a partnership for trading, manufacturing or mining purposes.
- are engaged in business for trading, manufacturing or mining purposes and are not associated in partnership with any other person or people, but use as your business name a name other than your own, or use in your business name your own name and some words or phrase that indicate more than one member is in the business (for example, “and Company”, “and Associates”).
Partnerships of six or more partners and all tax shelter partnerships must register with Revenue Canada to obtain a partnership identification number and file annual information returns.
The partnership agreement will provide the basis of understanding between the partners regarding their rights to share in profits and losses, the work for which the parties are responsible, continuity of the partnership where new partners are admitted or others withdraw, and what will happen should the partnership dissolve.
The Income Tax Act has provisions to allow the tax-free transfer of assets from an individual or a corporate partner to the partnership.
General partners are not protected from claims of creditors as they are jointly and severally liable for the debts of a general partnership.
Another form of partnership is the limited partnership in which there is a general partner along with limited partners. Typically, the limited partners will contribute capital and share in the profits of the business. The expression ‘limited’ means the partners are only subject to losses and liabilities to the extent of their invested capital. Limited partners cannot be involved in the management of the partnership.
The net profits of the partnership are allocated among the partners based on their right to share income. A partner’s share of profit or loss is reported on the income tax return for the year that includes the year-end of the partnership.
A corporation is a separate legal entity incorporated under provincial or federal law. The scope of the company’s operations will dictate the choice of a federal or provincial charter. For example, if you intend to restrict your operation to one province, a provincial charter will suffice. A federal charter allows a company to operate anywhere in Canada without the need to register in each province in which it does business. As a corporation is an entity separate from its owners (called shareholders) it can provide protection from both creditors and lawsuits. This idea is called limited liability (i.e., limited to the net assets of the corporation and the share capital of the shareholders). This limited liability will be restricted to the extent that financial institutions or suppliers require personal guarantees from the shareholders to transact business.
Your accountant and your lawyer should help with the formation of the corporation. Where there are several shareholders you should consider a Shareholder’s Agreement, which sets out guidelines if a shareholder wishes to sell out or purchase the share of the other shareholders.
As with a partnership, assets can be transferred to the corporation on a tax-free basis, if the appropriate income tax elections are filed. Typically, proprietorships or partnerships are incorporated after they have grown to a level where the benefits of limited liability and lower corporate rates of income tax outweigh the costs of incorporating. The corporation must file annual T2 Federal Corporation Tax Returns within six (6) months of the business year-end. Ontario, Alberta and Quebec require that separate provincial income tax returns be filed for corporations that are incorporated or doing business in the province.
To incorporate or not?
That is the question. Actually, it is several separate questions rolled into one.
In theory the decision to become a registered corporation should be relatively simple to make. Nevertheless, in practice it seldom is. Professional advice is vital to ensure that you understand all legal and tax implications before proceeding. Still, start by understanding what sort of decision you are making.
“The decision should be made from both a legal and a taxation viewpoint,” says Wayne Makowecky, tax advisor for Edmonton Roper in Abbotsford, BC. “Most people are interested in incorporating if it saves them income taxes and will limit their liability- which in essence means legal protection from creditors.”
However, a corporation is a separate legal entity and so must file an annual report with the Registrar of Companies. This means that both accounting and legal costs will be incurred annually, warns Makowecky. Also, there are the initial legal costs of incorporating. This can run between $1,000 – $1,200 and more if you are in a hurry- although several publishers provide inexpensive self-incorporation kits which walk you step-by-step through the paperwork.
“One of the most important reasons for incorporating is the income tax rate applicable to active business income earned within a corporation,” suggests Makowecky. “In BC for example, it is approximately 22% on the first $200,000 of active business income earned each fiscal year. This rate is lower than the lowest personal rate of tax of about 27%.” (This amount is based on 1991 figures, check with your accountant for current percentages).
However, he warns this should be regarded as a deferral of tax rather than an outright saving, since there is an additional tax cost when the shareholders remove such after tax corporate earnings from the corporation – such as when the corporation pays dividends.
“If you need all of the business income to live on, there is no tax incentive to incorporate because all of the income withdrawn from the company would then be taxed at the personal level anyway.” says Makowecky.
Of course, a corporation provides important legal protection for its shareholders (the owners). This can be very reassuring if someone sues you for damages – because the amount you could lose is limited to the assets of the business which probably won’t include your house and its possessions. Unfortunately though, banks and trade suppliers often demand personal guarantees from you before doing business. Being incorporated won’t protect you from these creditors should you run into trouble.
“If you are both a shareholder and a director of a company, you will be at risk for any amounts owed to Revenue Canada, the Workers’ Compensation Board and the GST people.” Added Makowecky.
Other tax liabilities may also be incurred. The transfer of business assets to a corporation may result in some GST and PST costs, to say nothing of property transfer and other taxes levied in some provinces if real estate is involved.
One less well-known aspect of incorporation is the tax advantage which may stem from an estate freeze. “In this estate planning mechanism,” says Makowecky, “the cost base of the shares of a corporation can be limited to an amount equal to the fair market value of your shares at the time the freeze is entered into. This can be used to pass along the future growth in share values to other family members or to business associates. This is accomplished on a tax-deferred basis only through a corporation.”
If some of this sound complicated, it is. Still, much of the information may not apply to your business at all. Advisors like Makowecky always stress to clients the importance of seeking expert assistance, but they usually also emphasise the need for most home-based businesses not to worry about the decision to incorporate. If you run a food- preparation business, for example, you probably should consider incorporating to protect yourself from ruin, if sued. Yet many home-based businesses, especially ones with incomes of less than $50,000 (after all deductions) have little need to bother about incorporating. Remember, you can always revisit the decision as your business grows, anyway.
*For specific advice about the decision to incorporate your business, contact your accountant and lawyer
- You get protection against creditors suing for access to your personal assets to pay loans or damages.
- A lower rate of tax is paid by corporations with net incomes above $50,000.
- Selling the business is easier because the owner and the company are separate
- entities. There is an impression of long term stability because the company continues upon the death of shareholders.
- Paperwork and government regulation increases.
- Operating losses, tax credits and other potential deductions against income tax are no longer available to you as the owner.
- Limited liability is less valuable if you are forced to co-sign loan applications and guarantee the company’s debts.
A society is a not-for-profit organization formed by five or more individuals and may or may not be be incorporated. Incorporated societies enjoy the benefits of being a distinct entity seperate from the individual members. All monies raised by a society is for use by the society itself and no funds or profits can be distributed to any member of the society unless appropriate compensation is provided to the society.
If a society chooses to incorporate, a lawyer should be consulted. Societies are incorporated in British Columbia according to the provisions of the Society Act*. Copies of the act and regulations are available from:
- Crown Publications in Victoria. (250)386-4636
- International Travel Maps & Books in Vancouver. (604)687-3320.
*It is imperative that every director and member of a society read the Society Act and regulations.
Cooperatives (Co-ops) differ from traditional businesses in that they are owned and democratically controlled by the people who use their services. Co-ops are operated for the benefit of members and members must have a say in decisions affecting the co-op.
Since they are developed through consensus and run on the democratic principle of “one member, one vote,” co-ops can be more complex to set up and operate than traditional businesses. If you want to know more about co-ops you should contact a lawyer. To learn more go to the Canadian Co-operative Association (BC Region) website at www.bcca.coop
The first step in registering a new firm is to conduct a business name search. This can be completed online with a credit card at the OneStop Business Registry or at most Service BC Centres. Generally name search results are available within 24 hours of submission. If your searched name is available you will be granted a 56 day time limit for completing the registration process before your reservation expires. Community Futures can also submit your name search request for a $40.00 service fee. If you would like more information on this service please call Nicole Pipes at 250-364-2595 ext 23.
Business Name Criteria & Considerations
Is it a corporation, partnership, proprietorship, society or cooperative? You have three choices for a business name in the Name Approval Request process. It is strongly suggested that you use all three choices. Please note the Ministry of Finance only examines the request until a name is approved -If your first choice is approved they do not search the remaining two. Therefore, putting your choices in order of preference is very important. Your business name must have two components. The first part of your name must start with a distinctive non-descriptive word or phrase: e.g. a geographical location, your name, a made up word or phrase, or initials. The second part of your name must describe what type of business you are in: e.g. hair salon, investments, car wash. A name that would meet the Government’s criteria would be Lydia’s Hair salon or Fruitvale Car Wash. Names that would not be approved are The Hair Store or The Car Wash. If you are incorporating a company you must add a third component called the corporate designation: e.g. Limited, Ltd., Corporation, Corp., Incorporated, Inc. If you are registering a sole proprietorship or partnership, a corporate designation is not used. For more instructions on researching your name request, read the 3 page PDF at the BC Ministry of Finance.
Until your company is incorporated, or your sole proprietorship or partnership is registered, you should not invest any money on the name, for example, signs, printing, advertising. The name is only on reserve and can be cancelled prior to incorporation or registration.