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Selecting the Right Business Structure
By: Annie Bailey
and Jessica A. Spataro
| Dec 6, 2019
When starting your own business, you have many exciting and important decisions to make. One decision includes selecting the type of business structure you wish to use. With the following information on the three main different business structures, we hope to make this decision a little easier for you.
1. Sole Proprietorship
In a sole proprietorship, an individual (the “sole proprietor”) carries on business for his or her own accord. Other than the sole proprietor, the only other people involved (if any) are employees. A sole proprietorship business is not a separate legal entity. This means the sole proprietor receives all of the benefits and incurs all of the obligations and liabilities associated with the business. Similarly, all income and losses are taxed directly to the sole proprietor at his or her personal tax rate.
Compared to the other business structures discussed below, setting up a sole proprietorship is relatively straightforward. However, the sole proprietor is bound by Ontario’s Business Names Act, which requires the sole proprietor to register the name it will be conducting business under if that name is different from the individual’s own name.
Advantages of a Sole Proprietorship
- Simple and inexpensive
- Sole proprietor has direct and complete control and decision-making power
- Few legal regulations and ongoing requirements
- Likely lower start-up costs compared to other business structures
- All profits flow directly to the sole proprietor
- Tax advantages, such as deducting business losses from personal income, which may be used to lower the sole proprietor’s overall tax liability
Disadvantages of a Sole Proprietorship
- Unlimited personal liability: all business and personal assets can be used to satisfy business debts and obligations
- Sole proprietor may not possess the diverse skills and expertise required, although this can be offset by hiring employees
- May be burdensome to carry complete control, for example, the business may stop if the sole proprietor is absent
- May be difficult to acquire working capital, since the sole proprietor is limited to his or her personal assets and the credit they obtain
- The business dissolves upon the sole proprietor’s death, unless sold or transferred
- Tax disadvantages, such as higher profits moving the sole proprietor into a higher tax bracket
A partnership exists where two or more people carry on business together with a view to profit. Typically, the partners will have a partnership agreement setting out the rights and obligations under the partnership. This agreement can override some of the provisions contained in the provincial statute that otherwise governs the partnership. It is a good idea to have your partnership agreement prepared by a lawyer with expertise in this area.
Like a sole proprietorship, a partnership is not a separate legal entity. As a result, partnerships are taxed at the partnership level: the partnership’s income and losses are passed onto the partners, based upon their applicable partnership interest, and taxed directly to each partner at their applicable tax rate.
However, property contributed to the partnership by the partners is “partnership property” belonging to the partnership itself. On dissolution of the partnership and after settling all liabilities, the proceeds from the sale of this property are divided amongst the partners, based upon their applicable partnership interest.
There are three types of partnerships in Ontario: general partnerships, limited partnerships, and limited liability partnerships. When choosing to operate under a partnership, it is important to understand which partnership structure you are eligible for and that best fits the needs of your partners. The main differences are as follows:
a. General Partnership: All partners have unlimited joint liability for the partnership, thereby making all partners liable to the full extent of their personal assets for the debts and obligations of the partnership. All partners can also bind the other partners with their business decisions.
b. Limited Partnership: A limited partnership has both general partner(s) with unlimited personal liability, and limited partner(s) who are only liable to the extent of the assets they contribute to the partnership. The general partner(s) actively manage the partnership, whereas the limited partner(s) are prohibited from controlling or managing the partnership.
This structure is useful for attracting passive investors because they can contribute capital with the safety of limited liability and without actively participating in the business, while still receiving tax benefits from partnership losses attributed to them personally.
c. Limited Liability Partnership (LLP)
Only professions permitted by law may operate under an LLP, and this structure is currently limited to lawyers, paralegals, and chartered professional accountants. The main benefits of operating under an LLP include that all partners can participate in the management of the partnership and they do not have unlimited liability.
Partners are not liable for the negligent or wrongful acts or omissions of another partner, employee, agent, or representative, but they are liable for their own negligence and the negligence of those under their direct supervision. They are also liable, to the extent of their interest in the partnership property, for the partnership’s obligations.
Note that all three partnership structures require registration under Ontario’s Business Names Act. The following advantages and disadvantages apply with some variation to each partnership structure.
Advantages of a Partnership
- Simple and inexpensive
- Flexibility to select the partnership structure and to prepare the partnership agreement to suit your needs
- Tax advantages, such as benefiting personally from business losses and capital losses
Disadvantages of a Partnership
- Unlimited personal liability, depending on the partnership structure chosen
- Partners are bound by and financially responsible for each other’s decisions
- Unless the partnership has a well-drafted partnership agreement, it is bound by the default statutory terms which may be undesirable, including automatic dissolution on the death of any partner
- Tax disadvantages, such as having profits and capital gains taxed personally
Unlike a sole proprietorship or partnership, a corporation is a separate legal entity. The corporation carries on business, owns property, is taxed as an individual entity, and retains liability for its obligations. Since liability remains with the corporation, shareholders can only lose the assets they contribute to the corporation, and directors are generally not personally liable for the corporation’s obligations (except in limited situations).
In a corporation, shareholders contribute capital and elect a board of directors with decision-making power. Shareholders can limit the decision-making power of the directors if they agree to enter into a unanimous shareholder agreement that gives the shareholders the power and liability otherwise assigned to the directors.
When deciding to incorporate, you must decide whether to incorporate under the provincial statute or federal statute. While the statutes for each jurisdiction are similar, there are important benefits and consequences of each depending on your business intentions. For example, incorporating at the federal level is advantageous if you wish to carry on business under your corporate name throughout the country instead of just within one Province.
Note that members of a regulated profession may also chose to operate as a professional corporation, which is subject to its own host of rules and responsibilities.
Advantages of a Corporation
- Separate legal entity
- Limited liability
- Flexible governance and share structures
- Continuous existence
- Easier to raise capital
- Tax advantages, such as possible capital gains exemptions and lower tax rates for qualifying corporations
Disadvantages of a Corporation
- Highly regulated, including regulations pertaining to director and shareholder meetings, filing deadlines, director obligations, shareholder rights, etc.
- More expensive
- Potential conflicts between shareholders and directors
- Tax disadvantages, such as individuals cannot personally benefit from business losses
We recommend speaking to a lawyer for further assistance in selecting the appropriate business structure to suit your business needs. We also recommend speaking with your accountant or financial advisor to understand the potential tax implications and liability with respect to the various business structures.