One important decision business owners face when they consider their options for growth is what legal structure to use. Here are the three main structures and their key pros and cons:
A sole proprietorship has one owner/operator in charge of all aspects of the business, from securing capital to managing day-to-day operations. This is the cheapest and simplest way to set up and maintain a business. There are also tax advantages, including the proprietor’s ability to offset their income from other sources with the business’s losses. A sole proprietorship does not file a separate tax return, and all the business’s income and losses are included in the proprietor’s income (taxed at their personal tax rate). However, a sole proprietor also assumes all the business’s risks and liabilities, and their personal assets could be used to satisfy the business liabilities. Owners often use this structure until a business becomes profitable, when a corporation might be preferable because it can retain earnings.
A partnership is two or more people carrying on business together, pooling their resources, dividing management responsibilities, and sharing the profits and losses. There are two kinds of partnerships: general and limited. A partnership agreement setting out each partner’s rights, interests, and responsibilities is a good idea; without one, legislation governs the partners’ relationship. Also simple to set up, a partnership allows multiple people to pool funds and talents. A partnership isn’t a separate taxable entity but does allow partnership losses and income to flow through to the individual partners personally (as allocated in the partnership agreement); this is especially useful if a business isn’t yet profitable. However, in a general partnership each partner is jointly and severally responsible for the partnership’s liabilities, so each is responsible for liabilities incurred by (an)other partner(s) while acting in the ordinary course of their business. A limited partnership has both general and limited partners. A limited partner participates in the business only by contributing capital and is liable only to the extent of their contribution (not for liabilities another partner incurred). Having multiple owners can also lead to conflict, though a partnership agreement can help avoid or resolve disputes.
A corporation is a legal entity separate from its owners (the shareholders), with all the rights, powers, and privileges of a natural person. The owners manage the corporation through the election of directors, but aren’t otherwise entitled to participate in business operations. Properly structuring and incorporating from the outset helps avoid disputes, protects the corporation by addressing how disputes are dealt with, and eliminates the time and expense of restructuring. Shareholders are generally not liable for the corporation’s debts, obligations, and actions. There are also tax advantages to incorporation, especially after a business becomes profitable. Plus, since a corporation is a separate taxable entity, shareholders are taxed only on income that flows to them through dividends or salaries, so a corporation can offer tax deferral by controlling when it issues dividends. There are also numerous ways to structure a corporation so it benefits from available income tax deductions and exemptions. Additionally, the business will probably require financing to grow, and obtaining that financing is sometimes easier for a corporation than for a sole proprietorship. Finally, since ownership in a corporation is transferable, incorporation can be a useful succession planning tool. However, a corporation is the most complex and expensive structure to set up and maintain, but offers limited (not absolute) personal liability for shareholders and directors. Directors remain exposed to personal liability under various federal and provincial laws, and directors and shareholders might have to give personal guarantees to obtain corporate financing. Finally, since shareholders are owners, incorporation creates the potential for disputes between them, although a shareholders’ agreement can help avoid or resolve those.
This article is information only; it is not legal advice. McInnes Cooper excludes all liability for anything contained in or any use of this article. © McInnes Cooper, 2019. All rights reserved.
Sheri Wicks is an Estates & Trusts and Commercial Lawyer in McInnes Cooper’s St. John’s office. She counsels business owners on matters ranging from wills and estates, including succession planning, to general corporate matters and commercial and civil litigation, including shareholder disputes and directors’ liability issues. Contact Sheri at email@example.com or 709.570.7360.