You have a business idea or have already started making some sales. As someone who has been dreaming to be an entrepreneur, one of the first steps in setting up a business is to choose your business structure. You may have heard of a sole proprietorship, a partnership, and a corporation. But what exactly is the difference between the three?
I will be diving into the three commonly used business structures in Canada, which are a sole proprietorship, a partnership, and a corporation.
Notice that I didn’t mention an LLC, which is actually a business structure that exists and is commonly used in the US, but does not exist in Canada. So if you want to learn about what your options are as a Canadian business owner, make sure to keep on reading.
A Sole Proprietorship is the easiest and inexpensive to start a business. You don’t even need to register your business if you operate under your own legal name, like Jane Doe. However, if you are operating under a different name, such as Jane Doe’s bakery, you do need to go through some extra steps such as name and business registration.
In the eyes of the legal and tax authorities, you and the business are considered the one and the same. There are many elements on whether to consider the different business structures, but usually legal and tax are the main two things.
From a legal perspective, you are personally liability for all debt in the business as well as if anything goes wrong. So if you get sued from a customer for whatever reason, your personal assets are at risk. Though, this is usually something to consider depending on the nature of your business and how risky it is. For example, manufacturing baby cribs are very high risk compared to landscaping.
From a tax perspective, it’s reported as part of your individual tax return so it’s simpler to report. That means all of the profits of the business is taxed at your personal income tax rate. If you are making lots of profits, this will be unfavourable since it would be subject to your highest marginal tax rates. However, if you are making losses, you may be able to offset it against other sources of income, such as your employment income.
There are many different forms are partnerships, such as general partnership, limited partnership, and limited liability partnerships.
General partnership (GP) is similar to a sole proprietor, but instead, you have two or more operators pooling their resources to make a profit. Similar to a sole proprietorship, the partners have unlimited personal liabilities, and the action of one partner can legally bind one another without prior approval.
A partnership agreement would govern how revenue, expenses, and tasks are split among the partners. General partners can be a husband and a wife who are starting a business venture together, and are actively involved in the business itself.
Limited partnerships (LP for short) are different from general partnerships in that they have a different legal status from its partners. What I mean by this is that there are usually two types of partners in a LP: limited partners and general partners.
Limited partners are typically investors who are not involved in the day-to-day operations and their liability is limited to their investment, whereas general partners run the business and have unlimited liability. LPs are usually used in real estate developments and in the film industry.
Limited Liability Partnerships (LLP for short) are more similar to a corporation in that the partners have limited liability in that it is capped to their investment amount in the LLP. Usually this structure is used by professionals such as doctors, lawyers, accountants, architects, and engineers.
For partnerships, they are a flow through entity, meaning that they are itself subject to tax. Instead, the partners are taxed on their allocation of income and expenses based on the partnership agreement in place.
More complicated legal structure in which a business becomes incorporated, and it’s now considered a separate legal entity (ie. different person from you). You would have ownership over the corporation as a shareholder. As a small business owner you would often not only be a shareholder, but an employee as well.
From a legal prospective, a corporation provides separation over your personal assets. So if the corporation gets sued, your personal assets are not at risk but limited to the corporation. Same with debt, if the corporation is not able to pay its loans, creditors can’t personally go to you for money. There is something called piercing the corporate veil, where if you conducted fraud, you may be personally liable.
Corporations can exist forever, so it can continue to operate even after your death. For this reason, other reasons to incorporation include estate planning where you can pass on your legacy to your kids, or you can grow you company and sell your ownership in the company.
Perhaps one of the biggest benefits to incorporate are the reduced tax rates for small businesses. The tax rates vary depending on the province, in BC, the rate is 11% on the first $500k of taxable income!
There is a lot of advice floating around, even from some professionals, that incorporating is always the way to go because of this tax benefit. I want to give you a heads up that this might not necessarily be the way to go and can actually put you in a disadvantage financially if you incorporate too soon.
Each person’s situation is unique, and in order to better determine if incorporation will actually save you money, there are a couple of factors to consider, such as your income level (if you are still working a 9-5), how well your business is doing, how much your expenses are if you are planning to make big purchases, how much you need to pay yourself from the business to support your living, etc.
Not to mention, there are definitely cons with incorporation, as its going to be much costly and more complicated to maintain than a sole proprietorship. There is a higher level of compliance that is required of you from the government and the tax authorities. You would need to file annual reports, prepare financial statements, and file corporate tax returns (on top of your personal returns).
There are also more tax planning considerations to be made since there are two separate entities - you and the company, which means you can’t simply withdraw money from the company like you would in a sole proprietorship. For example, paying yourself a salary vs a dividend would make an impact on how much taxes you pay.
Disclaimer: Note this post is not financial nor accounting/tax advice and should be used for entertainment purposes only. Consult with your own financial advisor, accountant and/or tax advisor for specific advice related to your business situation and needs.