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How to Choose the Best Legal Structure for your Business?

Last revision:
Last revision: October 14, 2019
Last revision:
Category: Business Formation and Structure

When starting a new business, choosing the right business structure is essential and must be aligned with he goals of the owners. In Canada, there are three different ways to organize a business: sole proprietorship, partnership, and incorporation. The choice depends on several different factors and their relative importance to the business owners.

Sole proprietorship

Sole proprietorship is the simplest, most common and least expensive type of business structure: it is a business with a single owner, who is a physical person and who alone is responsible for all the business' liabilities.

Liabilities are defined as a business' legal financial debts or obligations that arise during the course of business operations.

Sole proprietorship is the simplest of the three ways of organizing a business. All it requires is for the business owner to:

  • Register a trade name;
  • Obtain a tax number; and
  • Open a bank account.

Once a sole proprietorship has been established, the business and its owner are considered the same from a tax and legal standpoint. Because of this, owners of sole proprietorships sometimes prefer to use lawyers as well as tax and accounting professionals to help with the legal and financial aspects of running their business.

A sole proprietor may have municipal, provincial, and/or federal licensing requirements, and must comply with provincial or territorial legislation regarding business names. For example, section 2(2) of the Business Names Act (Ontario) states that no individual may carry on business or identify his or her business to the public under a name other than his or her own, unless the name is registered by that individual.


(i) Benefits of a sole proprietorship

  • Relatively simple and inexpensive to establish;
  • Requires few legal formalities;
  • Owned and operated by a single individual;
  • All benefits flowing from the business accrues exclusively to the sole proprietor; and
  • Sole proprietor has direct control over the decision-making.


(ii) Drawbacks of a sole proprietorship

  • Losses flow to the sole proprietor;
  • A sole proprietor's liability is unlimited, and all business and personal assets may be seized in satisfaction of the sole proprietor's business obligations (the liability of a sole proprietor may be limited through insurance or contract);
  • Financing of this business structure may prove to be difficult; and
  • Not an effective arrangement for multiple owners.


Partnership

When two or more persons, whether individuals or corporations, carry on business together with a view to profit, the relationship is called a partnership. The members of the partnership are called partners. The partners carry on the business themselves directly, since a partnership is not a legal entity separate from its partners. In a partnership, all partners have a duty to one another to be loyal and act in good faith and cannot compete with the partnership.

A Partnership Agreement governs the relationship between partners. The Partnership Agreement should clearly establish the terms of the partnership with regards to issues such as decision making among the partners, day-to-day management, profit sharing, dissolving the partnership, and business funding.

A partnership may have municipal, provincial, and/or federal licensing requirements, and must comply with provincial or territorial legislation regarding business names.

There are essentially two forms of partnerships: general and limited partnerships.


(i) General partnership

There are three essential elements to a general partnership:

1. a sharing of profits and losses;

2. a joint ownership of the business; and

3. an equal right in the management of the business.

A general partnership is relatively simple to form as there are no formal legal requirements. Usually, the partners will work out a Partnership Agreement that outlines their respective powers, ownership share and capital contribution as well as the profit distribution and operating procedures for the business.

(I) Benefits of a general partnership

  • Easy to establish;
  • Few legal requirements;
  • Increased ability to raise capital; and
  • Suits the needs of partners who wish to be equally involved in the business.

(II) Drawbacks of a general partnership

  • Partners are jointly and severally liable for the actions of other partners: if the business does not have enough assets to satisfy business debts, creditors can use the personal assets of the partners to satisfy the liabilities of the partnership;
  • Partners are jointly and severally liable with respect to the partnership: if a third party were to bring a claim against the partners, the third party can claim against any one of the partners without claiming against all of them. If a claimant is successful, the amount owing by the partnership can be satisfied by the assets of any or all of the partners; and
  • Less stable than corporations as a partnership is not a separate entity from its owners.

Without a written Partnership Agreement to govern how the partnership will be dissolved, there is a danger of dissolution if one partner wants to withdraw from the business or dies during the partnership.


(ii) Limited partnership

A limited partnership is an arrangement where a limited partner can contribute financially to the business without being involved in the affairs of the partnership. As a limited partner, liability to the partnership or its creditors is limited to the amount invested. Limited partners are sometimes referred to as 'silent partners', as they contribute capital, but do not share in the management or liabilities of the partnership. It is a legal requirement that in order for the liability of a limited partner to remain limited, the limited partner must take no part in the management of the partnership or act on behalf of the partnership. If a limited partner does not abide by these restrictions, the limited partner may be deemed to be a general partner.

Every limited partnership must have a general partner, who is responsible for the day to day operations of the business. Unlike the limited partners, a general partner has unlimited liability.

Finally, because of the characteristics of the limited partnership, if the partners plan on evenly contributing to the day-to-day business operations, a limited partnership may not be an appropriate business structure.

(I) Benefits of a limited partnership

  • Limited liability for the business debts for the limited partner;
  • Limited partners get to share profits and losses without having to actively participate in the business itself; and
  • Easier to attract investors.

(II) Drawbacks of a limited partnership

  • Difficult to finance a limited partnership beyond the resources of the limited partners;
  • If more funding is needed beyond the investment of the limited partners, the credit of the general partner will likely be required to obtain financing; and
  • If a limited partner becomes active in the business, he or she may be deemed to be a general partner, and therefore attract personal liability. As mentioned above, the general partner is personally liable to the full extent of his assets for the debts of the partnership.


Incorporation

A corporation is the most common form of business organization in Canada. A corporation is a legal entity, separate in law from its owners the shareholders. A corporation can own property, carry on business, possess rights, and incur liabilities separate from its shareholders. Although the shareholders own the corporation through their shareholdings, they do not own the property belonging to the corporation, nor are the rights and liabilities of the corporation passed through to the shareholder.

If a corporation carries on business under a name other than its corporate name, it must register the business name under the appropriate provincial or territorial legislation.


(i) Federal vs. Provincial

If a corporation is chosen as the appropriate form of business organization, a business owner must consider under which jurisdiction to incorporate. In Canada, both provincial and federal statutes govern corporations. The Canadian Business Corporations Act ("CBCA") governs corporations incorporated federally. Provincial legislation, such as the Ontario Business Corporations Act, governs corporations incorporated in a province or territory. The choice of which statute to incorporate under will be informed by the nature of the business.

A federally incorporated corporation has the right to carry on business and use its name in all provinces. By contrast, a corporation incorporated under provincial legislation can only carry on business in the province it was registered, unless it applies to be registered extra-provincially in another province, which may not be granted if, for example, the name of the Ontario corporation is not acceptable in the province where the extra-provincial application is filed. Provincial legislation and CBCA have varying requirements with respect to filings, directors' meetings, naming of the corporation and more.

The shareholders are the individual entities who own "shares" in a corporation. Shares are representative of ownership, so the shareholders are the actual owners of the corporation. Through a Shareholders Agreement, the corporation and the shareholders agree to the bounds of the relationship between them. Within these agreements, the corporation lays out its expectations of the shareholders' behaviour and obligations and the shareholders establish the set up for the major players in the corporation - these major players include the shareholders themselves and the directors.

Directors are the individuals who help manage the broader structure of the corporation and act on behalf of the shareholders.


(ii) Benefits of incorporating

  • Corporations enjoy perpetual existence; the corporation's existence does not depend on the business' owners;
  • Corporation are the most flexible structures from a financing perspective. Corporations can easily finance their business through the issuance of debt instruments, or by issuing equity to shareholders. Assuming compliance with all relevant securities regulations, these shares and debt instruments can be transferred, which allows flexibility to investors.
  • Shareholders' liability is limited to the value of the assets they have transferred to the corporation. Furthermore, the managerial decisions remain with the directors of the corporation, who are appointed by the shareholders.
  • Tax savings: in general, corporate tax rates are lower than personal tax rates, a corporation has to generate substantial profit before this becomes an advantage;
  • Income splitting and dividends: splitting business income with family members may present in significant tax advantages;
  • Losses may be applied to future income; and
  • Selling the business: as of 2016, one may claim a one-time capital-gains tax exemption of $800,000 on the sale of a Canadian-controlled private corporation that uses at least 90 percent of its assets to do business in Canada.


(iii) Drawbacks of incorporating

  • Establishing a corporation can be costly; these costs will often exceed that of a partnership or a sole proprietorship. Aside from the government fees associated with creating a corporation, there are also additional legal fees to be considered;
  • Corporations are more closely regulated than other business structures: for example, the issuance of securities to prospective investors requires compliance with securities regulation, which can become costly for the corporation; and
  • Extensive corporate records are required to be kept, including documentation from shareholder and director meetings and documentation to be filed annually with the government.


Questions when choosing a business structure

When choosing a business structure, owners may want to consider the following:

1. The time and effort they are willing to put to set up the business.

2. The time an effort the owners are willing to put in to maintain the business.

3. The importance of tax advantages.

4. The level of personal liability with which they are comfortable.

5. Whether they need to raise capital easily.

After considering these, with the information provided above on the different business structures, choosing the the right structure for the owners' needs should be easier.


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