Conceptualizing the product or service of your business, developing your business model, identifying your market, communicating to that market, pricing your products and services, financing your start up, managing and staffing your business and managing your books and taxes are among the items on an exhausting list of requirements and aspects of a start-up that must be dealt with. With all of this and more to contend with, it is no surprise that entrepreneurs almost always neglect to properly consider the legal structure of their business ventures.
Whether it is appropriate to run the business as a sole proprietor, a corporation or other structural options, the result of this decision will be the foundation for your operations. It will affect your personal risk, your cost of administration and the tax ramifications of your enterprise.
The conversation around business structure is often a very technical one, which is typically left for one’s accountant to determine, however, do not trust your accountant to understand and see all of the nuances of your business. Having at least a basic understanding of the structural choices and their relative pros and cons can help both you and your accountant make the most appropriate choice for your business.
Below I have attempted to summarize each of the major structural options facing a project, venture or business, and for each, discussed their qualities and the considerations one must review in choosing them.
A Sole Proprietorship is an unincorporated business activity operated by a single individual (Sole Proprietor). As a Sole Proprietor, the individual includes all profits earned by the business within their personal income tax return. A Sole Proprietor owns all of the business assets directly, and is personally responsible for all business liabilities. All of the Sole Proprietor’s personal assets may also be at risk in the event of a business loss or judgment. The Sole Proprietor may deduct valid expenses from the business and may be required the file and manage GST.
The principal benefit to a Sole Proprietorship is cost and simplicity. The only cost to establishing a Sole Proprietorship is the registration of the business name (if applicable) and any relevant business licenses. There are savings over a corporation, as there is no need to maintain separate accounting records or file a separate tax return.
In a Sole Proprietorship, there is no legal separation between the business and the individual. The major consideration in choosing a Sole Proprietorship is the lack of legal separation between the individual’s assets and the business activity. Personal bankruptcy is a risk in the event of a business mistake or lawsuit, both of which can be difficult to foresee. An individual should choose a Sole Proprietorship with full awareness of this risk.
A Corporation is its own entity under law. It manages income tax, acquires assets, incurs liabilities and acts independently and separately from its shareholders. The principal purpose of a corporation is the limitation of liability it grants its shareholders. Theoretically, a shareholder bears no responsibility for the actions of the corporation (unless they are also a director or officer of said corporation).
There are many types and classifications of corporations ranging from individually owned small businesses to large public companies, and different tax treatments depending on the nature of the corporation’s business activities, holdings, and the residency of its shareholders. Most small and medium sized enterprises in Canada would be classified as a Canadian Controlled Private Corporation (CCPC) which as the name suggests is a corporation of fewer than 50 shareholders, the majority of whom are resident in Canada.
A CCPC can be registered provincially or federally which either grants permission to operate the business under the registered name in the resident province, or all across Canada.
A Corporation is taxed differently than an individual, and is subject to different income tax rates depending on its level of income, and the nature of its business activities. Income earned by a CCPC from the active and ongoing sales of its products and services is taxed as ACTIVE income. Active income is taxed at the general business rate (25% in Alberta, 2012), although the first $500,000 of annual active income earned by a CCPC is eligible for the small business deduction and thereby taxed at a preferentially lower rate (14% in Alberta, 2012).
A corporation’s income earned off of property such as investments and/or real estate, without the addition of value in the form of products or services, is taxed as PASSIVE income. Passive income is taxed at a rate substantially higher than the general business rate (44.5% in Alberta, 2012).
There are many advantages and reasons for incorporation, which makes this the most popular holding structure for business activities. Principal among the advantages is the liability shield granted to the shareholders from the activities of the corporation. Another major benefit to incorporation is the ability to earn income at a rate lower than the personal tax rates, and thereby retain more cash for reinvestment and growth.
Incorporating a business activity gives the activity a life separate from the shareholders and principal. This theoretically allows a business to continue uninterrupted despite any changes in the shareholding of the corporation.
Maintaining a corporation can be costly depending on its activity level. At the very least, any corporation must keep current its annual filings, and must maintain its separate financial records from its shareholders, prepare its own income tax returns, and in most cases manage its own GST. This additional cost is the reason why many small businesses choose sole proprietorships or partnership structures instead. In addition to cost, an individual must be aware of the dynamics of multiple shareholders, and be sure to implement shareholder agreements and other measures to anticipate potential conflicts which may arise.
A Family Trust refers to a Discretionary Trust (Trust) which is established to hold a family or other group’s assets in the place of particular individuals or corporations. Typically, a Trust is set up for the purpose of Asset protection or as an income tax management tool. A Trust can also be an effective way to manage an estate while the benefactor is still living and can articulate his or her wishes.
A Trust must have: a Settlor, being the individual who actually creates the trust by donating the property to the Trust and establishes the rules and guidelines for its management; one or more Trustees being the individual(s) responsible for managing the property of the Trust and ensuring the established guidelines are being followed; and one or more Beneficiaries who are the current or future individuals designated to receive the financial benefit of the assets of the Trust.
Once a Trust is established, the Trust itself is the legal title holder to all of the property held by the Trust, to be managed by the Trustee for the benefit of the Beneficiaries. The Beneficiaries do not own the property. Income earned from the assets is distributed through the Trust to the Beneficiaries and taxed at the beneficiaries’ personal tax level. The nature of the income is preserved as it passes through the trust. In other words, income earned as a capital gain by the trust will be taxed as a capital gain to the Beneficiaries; income earned by the trust will be taxed as income to the Beneficiaries; dividends as dividends, and so on.
The death of the Trustee or any of the beneficiaries does not in itself have any income tax effect on the Trust. Every 21 years, however (for income tax purposes and not necessarily for real), a Trust is deemed to have sold all of its property at fair market value and owes Revenue Canada any resulting income tax which would have been due in that event.
A Family Trust can be a versatile and very effective planning tool. A Trust can provide a mechanism to income split among several individuals who otherwise would not have been associated with the underlying assets. A Trust can provide for beneficiaries who do not yet exist (i.e. future generations) which cannot be accomplished through shareholdings or other structural means. The principal use of a Trust, however, is the protection of assets from individual liability. Assets owned by a Trust are not subject to foreclosure or seizure resulting from the liabilities of its Settlor, Trustees or Beneficiaries.
Among the matters to consider when contemplating a Trust is cost. There is not an unsubstantial cost to setting up a Trust, or to its annual maintenance (depending on the degree of complication). In addition, the Settlor must be comfortable with the individual(s) designated as Trustees, and that they will be considerate custodians of the established guidelines for the Trust. Lastly, without proper planning, consideration and management towards the liquidity of the assets within the trust, the 21-year disposition rule could have catastrophic ramifications on the trust, forcing untimely liquidation of Trust assets in order to meet the income tax obligations. Proper management is the key to an effective Trust.
A Partnership is an unincorporated business activity by two or more individuals and/or corporations (the Partners) for which the profits, losses, acquired assets and/or incurred liabilities from the activity are shared proportionately by the Partners. A Partnership is not a distinct legal entity but rather an association by agreement and as such a Partnership does not retain income for tax purposes. Income earned by a Partnership must be included in the personal or corporate income tax return of each Partner proportionately. Furthermore, a Partnership in and of itself does not shield the Partners from their share of any liabilities incurred from the business activities of the Partnership.
There are two common types of Partnerships – General Partnerships and Limited Partnerships. In a General Partnership, each Partner shares equally in the roles and responsibilities of the Partnership. Each is entitled to his or her share of the profit(s) and each bears his or her share of the liabilities. A Limited Partnership is made up of both General Partners and Limited Partners which are treated the same, except that Limited Partners are limited in their share of any Partnership liability, to the value of their investment.
Partnerships are useful in structuring a joint business activity for which you wish to cooperate with other partners, but not to share in all of the ownership considerations that come with joint shareholdings in a corporation. Partnerships are typically used for large investments and/or for ongoing business involvements. Limited Partnerships can be useful for structuring investments, where the financial investor(s) wish to participate in the profits of the business activity but be insulated from the risks of management.
A Partnership structure is not a liability shield, and as a Partner you inherit your share of the Partnership risk and liability whether or not you are responsible for creating it. In addition, a Partnership does not offer any tax benefit over and above the structure that the Partnership interests are held in.
A Joint Venture is a business arrangement where two or more individuals or corporations work together for a defined and finite business goal. Whereas Partnerships may encompass an ongoing business relationship, a Joint Venture is typically limited to a specific goal.
The participants in the Joint Venture each contribute a share of the assets, expertise and effort needed to achieve the business goal, and share proportionately in the result of their efforts.
A Joint Venture is not considered a “person” for tax purposes, and therefore there is usually an “operator” designated from among the participants, whose business number and tax base is used.
A Joint Venture does not in itself provide a liability shield to the participants, unless those participants are already incorporated.
A Joint Venture can be a very effective and inexpensive structure for cooperation on a project where any given participant doesn’t have all of the needed inputs to be successful on his or her own. Joint Ventures are not legal structures and therefore do not have all of the associated costs of maintaining the structure found with corporations or partnerships.
Similar to a Partnership, a Joint Venture does not succeed in sheltering the participants from the risk and potential liabilities of the business venture. Furthermore, there is no distinct set of laws or regulations for the governing of Joint Ventures. A strong and specific legal agreement detailing each of the participant’s rights and obligations is strongly recommended.