By Catherine TIAN
Disclaimer: The information contained in this article is general in nature and does not constitute legal advice. Please contact the Law Office of Jeff J. Li, or another experienced business lawyer if you are concerned about your business law issues.
When choosing the most appropriate method of carrying on business, extreme care must be exercised since no one method is best in every case. There are ten major factors that need to be taken into consideration:
- Limited Liability
Sole proprietors and most partners are liable to the full extent of their personal assets for the liabilities of their businesses, whereas a shareholder’s liability to creditors of the corporation is limited to the amount of the shareholder’s investment. Therefore, if a substantial uninsurable risk is possible, a corporation is the preferable vehicle to limit a proprietor’s or partner’s liability.
2. Desirability of Perpetual Existence
Death or disagreement among the partners can result in the dissolution of the partnership whereas a corporation continues notwithstanding the death or withdrawal of a shareholder or director. A corporation with perpetual existence may be preferable to a partnership or sole proprietorship that relies for its existence on the survival of individuals.
If the venture is for a single project or a limited number of commercial transactions, consideration should be given to the partnership or limited partnership form since they can be dissolved more easily and expeditiously than a corporation.
3. Estate Planning
It may be preferable to use a method that will provide financial benefits to family members while keeping the busines under the proprietor’s control and direction. Such an objective can be achieved by carrying on the business through a corporation and a well-designed share structure. Passing on an interest in a busines under a will to one or more legatees is also best done through shares in a corporation.
4. Number of Proposed Proprietors
Where there will be a large number of owners, incorporation is preferable since the responsibility of one shareholder for the acts of the other shareholders is absent. Incorporation also provides established and accepted rules for control of the business and permits greater flexibility in financing. In addition, it may be simpler to transfer shares in a corporation than to either execute new partnership agreements or amend existing agreements upon the admission of new partners.
5. Relationship of Proposed Proprietors
A significant consideration is whether it is intended that each proprietor take an active role in the affairs of the business. If some proprietors wish to limit their risk or have greater security for their investment or if there are to be several degrees of control and risk-taking, a limited partnership or incorporation may be preferable.
One disadvantage of incorporation to note is that minority shareholders are subject to the will of the majority, and their shares are not very marketable in the absence of a compulsory buy-sell agreement on the withdrawal of a shareholder. By contrast, if a partner wishes to withdraw and the majority will not buy the partner out, the partnership can normally be dissolved and the assets liquidated.
6. Employees
If the owners want to allow employees to participate in the growth and profits of the business without giving them the management rights of a partner, a corporation or a limited partnership should be used. It should be noted that a limited partnership is not available if it is intended to give the employees an interest as a limited partner in return for the employee’s services only. A corporation must be used if the employees are also to be owners, since employees may not be general partners.
7. Costs
The legal and accounting costs of creating and maintaining a corporation will often exceed that of a partnership or limited partnership and almost always exceed that of a sole proprietorship. Corporations must keep records specified by statute, comply with certain formalities and procedures to withdraw capital, and qualify to carry on business in other jurisdictions. These are continuing and additional costs not required to the same extend by the law governing sole proprietorships or partnerships.
8. Residency Requirements
Both Ontario’s Business Corporations Act (OBCA) and the Canada Business Corporations Act (CBCA) contain certain residency requirements in respect of directors of corporations. Twenty-five percent of the directors of a corporation governed by the OBCA or CBCA, other than a non-resident corporation, shall be resident Canadians, but where a corporation has less than four directors, at least one director shall be a residence Canadian.
9. Flexibility of Structure
In a partnership, one is left with considerable latitude to structure the arrangement between the parties. By contrast, many of the rules governing the relationship among shareholders are mandatory. Nevertheless, the ability to include in the articles of incorporation provisions that may be contained in by-laws and the availability of a unanimous shareholder agreement (USA) provide considerable flexibility for structuring arrangements among shareholders.
10. Income Tax
Unquestionably a most important and often the determining factor will be the impact of income tax directly and indirectly on the proprietor. While the income or loss of the busines carried on by a partnership is determined at the partnership level, that income or loss is taxed in the hands of the partners. Conversely, each partner may, subject to certain rules, use the partner’s share of losses of the partnership to reduce income from other sources in the current year, the three preceding years, and the next 20 years.
The income or loss of a business carried on by a corporation is both computed and subject to tax at the level of the corporation. The losses are the corporation’s and may be applied only against the corporation’s profits for the same carryover period for tax purposes, not against the shareholders’ income. When a corporation’s after-tax income is distributed to its shareholders by the payment of dividends, these dividends are generally taxed again in the hands of the shareholders.
If an individual is going to carry on business alone, expects the business to lose money in its early years, and has other income, it may be preferable to carry on the business as a sole proprietor rather than through a corporation in order to reduce the amount of income tax that must be paid.
In contrast, carrying on business through a corporation have the advantages of lower rate of tax (i.e. the 26.5% regular corporate tax rate) and deferral of personal tax while the after-tax business earnings are retained inside the corporation.
Further, if a business is carried on through a Canadian-controlled private corporation (CCPC) that earns active business income (ABI) qualifying for the small business deduction (SBD), less immediate tax will be paid. In 2019, a CCPC in Ontario is taxed at 12.5%, which is 14% less than the regular corporate tax rate of 26.5%, on the first $500,000 of ABI in each year.