If you are thinking of starting your own full time or side business, it’s very important to select the most suitable business structure from the beginning.
There are many business vehicles that exist, each with a different degree of risk/liabilities and tax consequences, and each with its unique advantages and disadvantages.
Sole proprietorship is the simplest business structure, where you are the only owner of your business. Anyone who works with you are considered your employees or independent contractors.
- Easy and inexpensive to set up
- Working for yourself à less likely to have disagreements or stalemates with co-owners or partners
- Unlimited liability
- All business earnings are your personal earnings
- All business losses are your personal losses
- If anyone sues your business, they can also come after your personal assets such as your car or house
- While sole proprietorship is easy to set up and operate, you still need to obtain all relevant licenses required for your business
- There are federal, provincial, and municipal licensing requirements
- For most small businesses, the municipal license requirements are the most relevant, and those requirements may different significantly from city to city.
- Examples (City of Toronto): liquor license, commercial parking lot license, hair styling license.
Other Restrictions and Compliance Issues:
- Example: some Toronto areas are considered “Toronto’s Business Improvement Areas”; if your business is situated in those areas, you must follow their rules regarding whether and where you can place physical signs and how you can decorate your exterior physical premises
- Very similar to employment income à all earnings and losses are included in your personal income, and then your personal income is taxed at the marginal tax rate that’s applied to individuals
- “Source of income”
- Only income and losses in the same category can be used to deduct against each other
- Example: capital losses may only be used to deduct capital gains, and cannot be used to deduct employment income
Generally speaking, partnership refers to any relation that subsists between persons carrying on business together with a goal of earning profit. “Persons” may be ndividuals or corporations.
It’s essential to clearly define the partnership relationship via partnership contracts, because decisions made by one partner may be binding on the other partner(s).
Three Main Types of Partnerships
- General Partnership: each partner has unlimited liability, similar to a sole proprietorship
- Limited Partnership: has at least one general partner who has unlimited liability (meaning that partner’s personal assets may be claimed by creditors) and at least one limited partner who has limited liability (meaning that partner would only suffer losses up to the amount of money he/she put into the partnership)
- Limited Liability Partnership (LLP)
- May only be used by certain type of professionals such as lawyers and accountants
- Each partner’s business losses is limited to the money they put into the partnership
- However, each partner is individually responsible for their own negligence or the negligence of staffs who are under the partner’s direct supervision and control; usually enforced by their professional licensing board (e.g. Law Society)
- Partnership itself is not taxed
- All income and expenses are deducted against each other within the partnership — the “partnership” is considered a “source or category of income”
- The partnership net profit or loss (after income and losses are deducted against each other) is divided amongst the partners, and this profit/loss is included in each partner’s personal income for tax purposes
It’s very important to have well-drafted partnership agreements in place. Below are several considerations that should be in a partnership agreement:
- How to divide up assets and liabilities
- How much and what form of contributions must each partner make to the partnership
- What is the authority of each partner (e.g. can each partner individually obtain loans, seek investors, choose suppliers, issue cheques?)
- Are there any restrictions in transferring partnership interests?
- Confidentiality and non-competition clauses
- Dispute resolution – what happens if the partners disagree on a major decision and reach a stalemate?
Partnership vs. Co-ownership
- Co-ownership: consist of persons who own property together
- each owner (if they are tenants in common) has their own separate interest in the property and can freely deal or sell his/her interest in property
- Partnership: each partner has no separate interest in any property owned by the partnership
- Each partner may only sell his/her partnership interest, but not his/her interest in the property owned by the partnership.
Unlike other business structures, corporation is a legal entity or “person” by itself.
- Shareholders of a corporation has limited liability, as anyone who sues the Corporation can only come after the Corporation’s assets, and cannot go after the shareholders’ personal assets; hence, the shareholders’ interests are limited to money they have put into the Corporation
- Caveat: if a shareholder use their personal capacity to guarantee an obligation on the Corporation’s behalf, then that shareholder is personally bound; example: if a shareholder decided to use his house to guarantee a loan given to the corporation, then upon default the bank can come after that house
- Corporations have “perpetual existence”à corporation continue to exist despite frequent changes in ownership
- A corporation may only end or be dissolved by a resolution made by the majority of shareholders, by court order, or by operations of legislations (e.g. corporation breached legislations, causing its dissolution)
- To avoid unwanted dissolutions due to court order or breach of legislations, ensure you have a good corporate lawyer to guide you
- Corporations are good tool for estate planning
- Leaving corporate shares to beneficiaries is an easy and usually tax-free way (if it’s a private corporation) of passing on your assets.
- Corporation is taxed by itself
- Then, the corporate earnings are distributed to shareholders, and those dividends are taxed again at the individual level
- There is usually favourable tax rates for corporations and for dividends (it’s important to consult a corporate lawyer and/or an accountant for more details)
Other Types of Business Structures
In addition to those business structures, there are other business types including Joint Ventures, Licensing Arrangements, Franchises, etc. Those are beyond the scope of this article, but I may write another article dedicated to them in the future.
An essential element of those structures is having sufficient written agreements in place at the beginning.
As evident from the above, there are many structures to choose from when starting your own company.
It’s crucial to choose the most suitable business vehicle at the beginning to avoid costly and complicated situations and litigations down the road.
Of course, choosing wisely at the beginning can also reduce your risks, facilitate the business process, and help you save on taxes.
This article is only meant to give general legal information. For legal advice on your specific business situation, please consult a legal professional.