Starting a New Business: What Legal Form Should I Choose?
Authors: Nicola Geary, Xi Chen
When starting a new business, one of the most important considerations is what legal form you will conduct your business through. Canada offers a variety of options, including sole proprietorships, general and limited partnerships, and unlimited and limited liability corporations. Which one of these is right for you and your business will depend on a number of factors, including: where you will be doing business; how many owners your business has; what kind of liabilities your business may attract; and your personal tax circumstances. Always check with your tax and legal advisors before making any decision.
The three most commonly used business forms are the sole proprietorship, the general partnership and the corporation. We will discuss some of the pros and cons of each below.
The simplest of the three most common forms is a sole proprietorship. A sole proprietorship comes into existence automatically as soon as an individual carries on business without incorporation. There are no formal registrations required for its formation and no legal steps need to be taken to create a sole proprietorship.
There are legal requirements to be aware of, though. If your business has a name that is different from your own name, you may need to register your business name with the provincial government. If you have employees, you will need to obtain a business payroll number from the Canada Revenue Agency (CRA) to remit the appropriate amount of withholdings.
While simplicity is the sole proprietorship’s primary advantage, the fact that there is no legal distinction between the business and the individual owner does give rise to some potential risks. As there is no separation between the business and the individual, any liability that attaches to the business is an individual liability, and there is no limit to that liability. So if someone sues your business, they will be suing you personally. There are also tax consequences, in that the business income becomes your personal income and your personal tax rates will apply to that income.
Raising business capital can be a challenge for sole proprietorships. Without a separate legal entity, you are not able to split up ownership (there are no corporate shares to sell to third parties). As a consequence. if you borrow money for your business, that loan is your personal obligation. If you want to enterprise your business with any other person, you cannot be a sole proprietorship. That leads us to our second legal form of business, the partnership.
When two or more individuals or entities wish to carry on business together with a view to making profit, without any formal registrations, they are automatically carrying on business as a general partnership. Similar to a sole proprietorship, there is no formal filing required to start a general partnership, but a partnership will likely need to register a business name if the name of the business is something other than the name of the individual partners.
While no written partnership agreement is required by the Partnerships Act (Ontario), it is well worth considering drawing one up. A partnership agreement will set out the relationship between the partners (owners) of the business, including: how decisions are made; whether and how partners can sell their partnership interest to other parties; how profits are distributed; and when and how the partnership will terminate.
Even with a written partnership agreement, and with a registered business name, you should be aware that a partnership is not considered a separate legal entity under the law. All of the liabilities of the corporation (including for debts of the partnership, employment remittances, taxes, etc.) are considered the liabilities of the individual partners. If the “partnership” is sued, that is really the individual partners being sued. (There may be exceptions to this in Quebec. If your partnership is located in Quebec, you should consult local advisors.)
Because liability is unlimited, partnerships are generally not a good choice if you have a “silent” or passive investor in your business.
For tax purposes, a partnership is treated as a separate entity for the computation of income; although each investor’s proportionate share of all losses and income are attributed to each owner, and taxed in the owners’ hands.
There are also other types of partnerships called limited partnerships. A limited partnership has one or more “general partners” and one or more “limited partners.” A limited partnership can provide some of the benefits of a corporation, like limited liability for the limited partner, and some of the benefits of a partnership, like flow-through of income and loss. However, it is only appropriate in certain circumstances where there are passive and active owners, and should only be considered upon the advice of your legal and tax advisors.
The final legal form of business is a corporation. A corporation offers many benefits, but it is the most administratively cumbersome form of business ownership.
In Ontario, a corporation is created by the filing of articles of incorporation. The articles will set out the basic tenets for how your corporation will be established. It will include what your corporation’s name will be, how many directors your corporation will have, who the initial directors are, and what kind of shares will be available for issuance. The creation of shares allows for great flexibility in structuring your business. You can have one owner or many owners, passive investors, active investors, investors with different profit share entitlements, or some with no right to vote.
In addition, a corporation is a separate legal entity from its owners. That means that, barring some bad act or other unusual circumstances, the liability of a corporation stays at the corporate level, and the shareholders are not responsible for the liabilities of the corporation. The corporation can sue and be sued as a separate person, it can borrow for itself (although depending on the circumstances, a lender may want guarantees from the owners), and it can have its own employees. It is also a separate person for tax purposes. A corporation is required to prepare and file its own tax returns every year; indicating its income and losses that is taxed separately from its owners at the business tax rate. Any profits distributed up to the owners is taxed separately in the owners’ hands.
The “cost” to getting the benefits of a corporation is the administrative burden. There are ongoing requirements in order to keep your corporation active. You will have to have an annual meeting, make annual filings, keep the public registry up-to-date if there are changes in your directors, and prepare and file separate tax returns, which can add significant time and monetary costs to your business.
Unlike with a sole proprietorship or a partnership, some information about your corporation will become publicly searchable and publicly available. This information includes the corporation’s name, registered address, and directors’ names and addresses.
If you have more than one shareholder, it is highly recommended that you put a shareholders’ agreement in place. A shareholders agreement will set out the relationship between the shareholders and the corporation. It should set out how corporate decisions are to be made, under what circumstances can a shareholder sell their shares to a third party, and what happens if there is a disagreement amongst the shareholders. It may also include provisions such as confidentiality requirements and non-competition covenants.
Each of the above described legal business vehicles have advantages and disadvantages which need to be taken into consideration before choosing the appropriate vehicle for your business. In addition, different provinces and territories have differing laws concerning business entities. It is therefore important to consult the appropriate statute as well as the appropriate advisor before finalizing how you wish to structure your business.