The Legal Structure of Your Business

When you decide to start a business, one of the first decisions that you must make concerns the legal structure under which the business will operate. There are typically four ways in which you may carry on a business: as a sole proprietorship, a partnership, a joint venture or a corporation.

Sole Proprietorship

A sole proprietorship is the simplest, and cheapest, form of business organization to start and to maintain. It is a non-incorporated business entirely owned by one person. The owner retains absolute control over business decisions and is the sole owner of any profits from the business. Its liabilities are the personal liabilities of the business owner. As the business the sole proprietor undertakes the risks of the business for all assets owned. It does not matter whether the assets were for personal use or part of your business. You include the income and expenses of the business on your personal tax return.

As as result, there could be significant tax advantages to structuring your business as a sole proprietorship, particularly in the initial stages of your business if you are to incur business losses. However, one of the most significant downfalls of a sole proprietor structure is that there is no limited liability protection, and the proprietor could lose personal assets beyond those invested in the business. Therefore, before venturing as a sole proprietor it is important to discuss your liability exposure with a lawyer. Also, in a sole proprietorship structure, it may be difficult to raise capital, as the only form of financing is what the proprietor is able to borrow as an individual, and the ability to raise debt financing is contingent on the value of personal assets that the proprietor can provide as collateral.

Partnership

A partnership is established when two or more people agree to pool their financial, managerial, and technical resources in order to operate a business for profit. Partnerships are most commonly found in professions such as law and accounting. The definition of a partnership, as enumerated in provincial legislation, is the relation which subsists between persons carrying on a business in common, with a view to profit from the business. Each partner owes every other partner a duty to act in the best interests of the partnership.

Like a sole proprietorship, a partnership is not taxed as a business that is separate from its owners. The income from the partnership is included as part of the partners’ personal incomes and taxed accordingly. Partnerships may be created either by agreement between the parties, or by the conduct of the parties. However, where a partnership is the desired form of business structure, it is recommended that the partners draw up a written Partnership Agreement. This can help greatly in the settlement of any disputes that may arise in connection with the business of the partnership. Because two or more people will be in business together, they can combine their finances in order to invest more than either could have done individually. A partnership will most likely be able to borrow more than a sole proprietorship because creditors will have the collateral of two or more people instead of only one to secure their lending. Partners can also pool their talents so that each person can focus on his or her area of expertise in the business.

Like a sole proprietorship, partners in a partnership (other than a limited partnership) are also exposed to unlimited liability incurred by the business. However, unlike a sole proprietorship, each partner can legally bind every other partner, so a partner can be held personally liable for any debts, obligations or wrongful acts of another partner. As a result, management decisions may be more complex and more difficult to make, particularly when disagreements among partners occur. Start-up costs can be as high as, or even higher than, the cost of incorporating, once a properly drawn partnership agreement is taken into account.

Limited Partnerships are a special form of partnership, often used where investors want the tax treatment that comes from a partnership relationship, without incurring personal liability for all of the partnership debts. When a limited partnership is formed, one of the partners (usually a corporation with no assets, formed and controlled by the promoter of the investment for this sole purpose) is designated as the "general partner" and all other investors are usually designated as "limited partners". The partnership agreement then makes the general partner responsible for managing the business of the partnership. The limited partners are simply “silent” investors with no say in the business activities of the partnership. Any income earned by the limited partnership are directed to and taxed in the hands of the partners, and any losses incurred by the limited partnership are allotted amongst the partners and may become a deduction from the taxable income of such partners.

A limited partner is restricted in their ability to deduct losses and in aggregate cannot deduct losses which exceed the amount they have invested (the ability of a limited partner to deduct losses is restricted and professional tax advice should be received with respect to such restrictions). In the event the limited partnership is unable to meet its obligations, only the general partner will be liable for the debts of the partnership. The liability of a limited partner would be limited to the amount of capital the limited partner invested in the partnership. However, if the limited partner participates in the management of the partnership, that partner could lose his or her "limited liability" and may become liable for the debts of the partnership, the same as the general partner.

Joint Venture

A joint venture exists when two or more people agree to contribute goods, services or capital to one business enterprise. Currently, joint ventures are governed by the contract between the parties involved. A joint venture agreement outlines joint venture terms, contributions of each party, management structure and how the profits will be divided. It should also define the contributions of everyone involved, the management structure and the sharing of profits. You should retain the assistance of a lawyer in drafting and structuring your joint venture agreement.

Joint ventures avoid the partnership disadvantage of joint and several liability, and also allows each joint venturer to regulate their own tax deductions. That's a big advantage for joint ventures. However, a joint venture has sometimes been defined by the absence of key partnership elements. This means small businesses intending to enter into a joint venture agreement must thoroughly understand partnership elements and avoid using them in order to avoid being deemed a partnership rather than a joint venture. What might have started out being a joint venture could lose its joint venture advantage by being deemed a partnership, and inherit the disadvantages of a partnership instead. Again, because of the potential pitfalls in using this structure it is important to retain the assistance of legal counsel.

Incorporation

A corporation is a legal entity that has its own legal personality, distinct from its owners (called shareholders) and the individuals who manage and run its affairs and business (called directors and officers). The creation of a corporation occurs following the proper filing of the Articles of Incorporation (sometimes also called a Charter or Certificate of Incorporation) with the relevant federal or provincial government authority. The Articles of Incorporation contain information such as where the registered office of the corporation is located, the share structure of the corporation, the rights, privileges and conditions attached to each class of shares, the number of corporate directors and the restrictions, if any, on the transfer of shares and the type of business conducted by the corporation. There are many advantages of a corporate structure.

The primary advantage to incorporating a business is that, except in limited cases corporate shareholders are not liable for the debts and obligations of the corporation. A shareholder’s liability is limited to the amount of money which has been invested in the corporation by the shareholder. Except in some very limited circumstances (which are described in a previous blog entry), creditors have rights only against the corporation and not against the shareholders. The continued existence of the corporation is not dependent upon the life of its shareholders, directors and officers and will not be affected by changes in deaths or retirements of its officers since the corporation is considered a separate legal "person". This advantage allows for the orderly transfer of shares of the corporation. Also, because of its independent legal status, it may own property in its own right, enter into contracts and initiate a lawsuit (or have a lawsuit initiated against it).

Another advantage of a corporation is that it can issue various classes of shares (in addition to other debt instruments such as bonds) in order to raise capital. This is an attractive feature to investors because it allows for partial ownership of the corporation. There may also be tax advantages to incorporating your business, such as lower income tax rates and the carrying forward of losses from previous years to offset profits in subsequent years. It is also possible to separate the owners, directors and employees of the business within a corporation, whereas a sole proprietor is the owner and manager of the business, and cannot be his or her own employee.

There are however some disadvantages in using a corporate form. The cost to incorporate your business (i.e., government fees and legal fees) can be high when compared to the start-up costs associated with sole proprietorships and partnerships. There are also a number of ongoing legal requirements that a corporation must comply with in order to maintain its standing. Corporations are required to file annual returns with the government. If you incorporate federally, you will be expected to file one for the federal government, and one for provincial government. For provincial corporations there would be one annual filing for the province only. A corporation is required to maintain corporate records, elect directors, hold directors and shareholders meetings, and provide shareholders with financial information, among other duties. There are additional duties if a corporation offers its shares to the public. Income generated by a corporation is taxed at both the corporate level and shareholder level. A corporation must pay taxes on its income and the shareholders must pay taxes on the dividends (i.e., profits they receive from the corporation, although they receive a dividend tax credit to offset the taxation cost). Taxes may be minimized by offsetting the corporation's business expenses (i.e., salaries) with its income.