Corporate Structuring for Start Ups: Sole Proprietorships, Partnerships and Corporations
Are you looking to start a business in Canada, and are scratching your head as to what the best structure for your business would be? Below lies a bullet-point summary of the principal structures under which to conduct business in Canada – whether as a sole proprietorship, a partnership or corporation – as well as some commercial considerations and tax advantages to bear in mind before making any decisions: 1. Sole Proprietorships
What is a sole proprietorship?
A sole proprietorship is the most basic form of a business organization
A sole proprietorship exists whenever an individual carries on a business solely on his/her account, with no involvement from other individuals (with the exception of any employees taken on)
What are the advantages of a sole proprietorship?
Low start-up costs
Simplicity of formation
Sole control over the business
Reports business income every calendar year, same as an individual in Canada
What are disadvantages of a sole proprietorship?
Unlimited Liability – all business & personal assets are subject to seizure
Challenging to attract investments
Unable to offer equity incentives to employees, which may be attractive as a start-up that has limited funds to pay employees
What are the tax advantages of a sole proprietorship?
Able to offset any business losses of the sole proprietorship against other sources of income – really attractive for a start-up given it is likely incurring a lot of losses in the beginning
Tax Deferral Opportunity:
Business losses may be carried back for 3 years & carried forward for 20 years
Capital losses or non-business losses may be carried back 3 years & carried forward indefinitely, offset against capital gains only
What is a partnership?
A partnership is a relationship between two or more persons carrying on a business in common with a view of making a profit
A partnership can exist without a written agreement
There are two types of partnerships:
General Partnerships (“GPs”) – Each partner’s liability is unlimited to the full extent of their personal assets
Limited Partnerships (“LPs”) – Each limited partner’s liability is limited to how much they put into the partnership
What are the advantages of a partnership?
Low start-up costs
LPs can limit their liability risk as described above
What are the disadvantages of a partnership?
GPs are subject to liability risk as described above
Does not have a distinct legal personality separate from its partners, which means it cannot maintain its own liability in the way a corporation can – see below
What are the tax advantages of a partnership?
While a partnership is not a separate legal entity, the Canadian Income Tax Act (“ITA”) treats the partnership like a person resident in Canada in order to calculate each partner’s income
Income & loss of the business is calculated at the partnership level & then allocated at the partnership level, & then allocated to the partners
A partner’s capital gains can be offset by its share of the partnership’s capital losses:
As for sole proprietorships, this is a key advantage
For a corporation this is not possible, as there is no “flow-through” of the corporation’s losses to its shareholders – see below
What is a corporation?
A corporation is a legal entity separate in law from its owners
A corporation has the right to:
Carry on business
Maintain its own liability
Few differences in taxation compared to other structure:
While most shareholders file their income taxes on a cash basis, a corporation may not use the cash basis of accounting and must use the accrual basis
While a sole proprietorship can report its income on a calendar-year basis, a corporation may select its fiscal year on any 12-month basis
The actual total tax on corporate income is obtained by adding the applicable provincial rate to the federal rate
No “flow-through” of the corporation’s losses to its shareholders
Corporate income subject to double taxation:
at the corporate level; and
at the shareholder level, when distributed as a dividend
What are the advantages of a corporation?
Provides limited liability for shareholders – there is a ‘corporate veil’ between the corporation and its owners
Has a separate legal personality that exists perpetually (unless formally dissolved)
Flexibility when raising capital – attractive for start-ups raising funds
Provides legitimacy to the business model and allows for equity incentives – attractive to clients and investors alike
What are the disadvantages of a corporation?
More expensive to set up and more expensive to maintain – i.e. corporate annual filings and quarterly filings as may be required; transactional structuring complexity
Directors of the corporation have a duty of care under common law and may be directly liable if they knew or ought to have known their decisions would be in breach of the duty of care
The ITA can pierce the ‘corporate veil’ & hold shareholders personally liable for corporate tax-related acts – though only in clearly convincing cases of fraud, shams, or outrageously offensive conduct
The ITA can also pierce the ‘corporate veil’ in certain circumstances that hold directors personally liable – an example is liability for corporate taxes due to:
Improper payment of dividends
Failure to remit withheld taxes
What are the tax advantages of a corporation?
Generally, lower tax rate for corporations than for individuals (depending on your individual tax bracket)
Small Business Deduction (“SBD”) eligibility – Canadian Controlled Private Corporations (“CCPCs”) receive a further tax deduction on the first $500,000 of active business income*
Shareholders are eligible to receive federal dividend tax credits – which is done to avoid double taxation when the shareholder receives their share of the corporation’s earnings – see above
Scientific Research & Development (“SR&ED”) – Canadian government offers tax incentives for certain innovative taxpayers to deduct their expenditures & receive input tax credits (“ITCs”), which is especially attractive for tech start-ups
Lifetime Capital Gains Exemption (“LCGE”):
Utilized by shareholders of CCPCs when a shareholder disposes of his/her shares in the corporation and wants a tax break – so long as the shares qualify as shares of a small business corporation