By: Catherine Tian and Jeff Li
There are various methods of carrying on business. Choosing the appropriate form of business organization is the first, and possibly the most important, step when you start the adventure. Here we discuss the advantages and disadvantages of the three most commonly-used business vehicles: sole proprietorship, partnership and corporations.
- Sole Proprietorship
A sole proprietorship is the most basic form of business organization. It is relatively inexpensive to set up and requires few legal formalities. It exists whenever an individual carries on business for the individual’s own account without the involvement of other individuals, except as employees.
All benefits flowing from the business, such as income and assets, accrue exclusively to the sole proprietor. Correspondingly, all obligations including losses and contractual and tortious liabilities associated with the business are also the sole proprietor’s responsibility.
A major disadvantage of sole proprietorships is that there is no limited liability for the sole proprietor: all business and personal assets may be seized in satisfaction of the sole proprietor’s business obligations and liabilities.
2. Partnership
When two or more persons, whether individuals or corporations, carry on business together with a view to profit, the relationship is called a partnership. It is relatively inexpensive to set up, requires few legal formalities and the partners carry on the business themselves directly.
The income or loss of the business carried on by a partnership is determined at the partnership level and then allocated to the partners. Each partner’s share of that income or loss is included in computing that partner’s income for tax purposes. Various sources of income and loss flow through a partnership to the partners and retain their characteristics as to source and nature.
The laws of Ontario recognize three types of partnerships: general partnerships, limited partnerships (LP) and limited liability partnerships (LLP). General partnerships share the same disadvantage of a sole proprietorship: there is no limited liability for the partnership or the partners, as all business and personal assets may be seized in satisfaction of the partnership’s business obligations and liabilities.
In a limited partnership, the general partner(s) is/are responsible for the LP, and fully liable for all debts and liabilities of the LP. However, the liability of the limited partners is restricted to the amount of money or interest they have invested in the LP.
LLPs are the most common type of partnership used by groups of professionals who may wish to obtain the benefit of limited liability, but for whom it may not be advantageous to incorporate. While the assets of the LLP are available to satisfy debts and claims against it, a limited liability partner is liable only for his/her own negligence, including the negligence of employees under his/her direct supervision and control.
3. Corporations
A corporation is the most common form of business organization. A corporation is a legal entity separate in law from its owners. Shareholders own the corporation through their ownership of shares but they do not own the property belonging to the corporation.
Shareholders’ liability is limited to the value of the assets they have transferred to the corporation in the form of money, property, or past service, in exchange for shares. As a separate legal entity, a corporation’s income is determined and subject to tax separate from that of its shareholders. If any of the corporation’s after-tax income is to be paid to its shareholders, the directors may declare a dividend. Corporations offer certain income tax benefits, dependent on:
- the type of corporation: private, public, Canadian-controlled private corporation (CCPC), not-for-profit, and registered charity;
- the types of activities and income generated therefrom: from business activities or passive investments.
If a business has a high net income, incorporation should be considered as the corporate tax rate is significantly lower than that of an individual (such as the highest marginal tax rate). By not distributing all the income to its shareholders, the corporation may defer taxes that are otherwise payable, which in itself can be a huge advantage.
On the downside, the setup and maintenance of a corporation may be more complicated than that of a sole proprietorship or partnership. For example, there will be some costs involved for incorporation, and filing income tax returns each year normally requires the help of an accountant. For corporations with more than one shareholder, how to manage shareholder relationships, and whether a shareholder agreement is required? This is another aspect that should be considered in setting up or running a corporation.
Other methods of carrying on business include joint ventures, joint ownerships, franchises and licences, non-profit organizations, charities, and so on. They have different characteristics and involve different tax consequences. It is always advisable you seek professional assistance from a lawyer and/or an accountant before diving into the world of business.