Technology’s increasing role in Canadian society and the prominence of television shows like Dragon’s Den and Shark Tank have helped foster a rise in entrepreneurialism. In this climate, many barriers to entry into various marketplaces have been lowered. New businesses seem to be popping up at a rapid pace. However, what many entrepreneurs do not often discuss – and what shows like Dragon’s Den often do not consider – is the appropriate legal structure for their businesses. This leads to an obvious question: What is the best way to organize your business?
Generally speaking, the three most popular ways to organize a business in Canada are: the sole proprietorship; the partnership; and the corporation. Each of these structures has advantages and drawbacks. What is right for your business depends on its size, industry and often personal preferences.
Entrepreneurs who are just getting their business off the ground are likely candidates for the sole proprietorship. This is because the sole proprietorship is the simplest way to organize a business. Put simply, all an individual has to do is fill out a few forms, ensure the name of their business is compliant with Ontario’s Business Names Act and start earning revenue.
Moreover, in a sole proprietorship, the person operating the business “is the business.” This means that any earnings or losses attributable to the business are attributable to the individual themself. These earnings are then taxed at the individual’s personal tax rate which – although higher than some other forms of business organizations – allows for simple accounting.
One of the most important determinants in selecting a business structure is the issue of liability. Sole proprietors are exposed to unlimited liability. As a result, if a business owner wants to grow their operation, they could be putting themselves at tremendous financial risk, especially with respect to business debt that is personally guaranteed. The impact of these realities depends on the specific situation.
As the name suggests, the partnership is a business operated by more than one individual. Three types exist in Canada: the general, the limited and the limited liability partnership. Each of these has unique characteristics. Common among them is that the business dealings among partners is governed by a partnership agreement. Such an agreement can be tremendously flexible. For example, partners may agree to concentrate their respective efforts on specific areas of the business and may also structure their compensation however they want. This can be very attractive to business owners and entrepreneurs.
Unlike the sole proprietorship, partnerships earn income and incur losses at the partnership level. When these amounts flow through to the individual partners, there are specific income tax consequences which can be beneficial to an individual’s bottom line. However, in some cases, exposure to the acts of other partners can be a serious risk. For instance, in a general partnership, if one partner signs a major contract with a supplier and then the partnership breaches the terms of the deal, all of the partners may be on the hook for any costs associated. Despite these risks, if partners trust each other and have an iron-clad agreement, this structure can be conducive to growth and a successful operation.
Often viewed as “the next step” for a sole proprietor, the corporation allows a business owner to grow their operation with more flexibility. This is because the corporation is a “separate legal entity” which can own property, incur liabilities, issue shares and raise capital, all separately from the person running the business. Additionally, instead of tax being paid on a personal level, the corporation itself pays a lower corporate rate and pays out dividends to its shareholders if the directing minds of the company declare them. In slower or growth years, the company has the flexibility to withhold dividends and reinvest these funds into building the business. These alternatives are not open to some partnership structures or sole proprietorships.
Another advantage to a corporate structure is the extra layer of legal protection that is provided to those running the business. Unlike in a sole proprietorship, if a business is sued, the potential liability is limited within the corporation, taking some risk away from the shareholders. The shareholders usually only face liability for the amounts they put into the business or if they guarantee loans or financing.
Of course, all of the advantages of incorporating a business are prefaced by the added costs that are incurred by using this structure. These costs include the legal fees for incorporation, the costs of maintaining the corporation and ensuring that reporting obligations are satisfied.
What will work best for your business?
When deciding which structure is appropriate for your business, it is important to consider many of the issues noted above, including who is involved in your operation, potential tax consequences, liability concerns and scalability. Before jumping into operation, you should ensure that your business idea is underpinned by an appropriate business structure. You should also be open to alter this structure, especially if you are planning to grow or make an appearance on Dragon’s Den.
No matter the stage of your business, our experienced team of business lawyers can help you through this tough but important decision.
Logan Burnett is a graduate from the University of Ottawa law program. Prior to law school, Logan graduated concurrently with an HBA from the Ivey Business School and a BA in political science from Western University. Connect with Logan on LinkedIn.