Growing Your Business: 3 Structuring Solutions
Published:
July 13, 2017
Author(s):
When growing your business, you face many decisions, including choosing the business structure that is right for you. Your legal team can be instrumental in helping you choose. To get started, ask yourself:
- How much control do you want over the business?
- Do you want to share management responsibilities?
- How much profit do you anticipate your business will initially make?
- Do you want to be responsible for the actions of the business?
Here are the three main ways to structure a business and the key pros and cons of each.
1. Sole Proprietorship
A sole proprietorship has one owner/operator who assumes charge of all aspects of the business, from securing capital to managing day-to-day operations.
Pros. This is the least expensive and simplest way to set up and maintain a business. There are also tax advantages, a major one being that the proprietor can offset income they earn from other sources with losses the business incurs. A sole proprietorship does not need to file a separate tax return and all the business income and losses are included in the proprietor’s yearly income (though taxed at their personal tax rate).
Cons. A sole proprietor effectively is the business and therefore assumes all of its risks and liabilities. All of the proprietor’s personal assets could be used to satisfy any of the business’s liabilities. A sole proprietorship is often used until a business becomes profitable, at which point, a corporation might become a preferable structure because it can retain earnings.
2. Partnership
A partnership involves 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 is always a good idea when in a partnership. Without one, the applicable partnership legislation governs the relationship between the partners. A partnership agreement sets out the rights, interests and responsibilities of each partner, and can override many of the provisions of the applicable legislation.
Pros. A partnership is also simple to set up. An advantage over a sole proprietorship is that the business can pool the funds and talents of multiple people. A partnership is not a separate taxable entity, but does offer the ability to flow through partnership losses and income to the individual partners, which is especially useful in a business that is not yet profitable. Income and loss (including capital gains and losses) are calculated at the partnership level and allocated to the partners, who personally claim the income or loss, pursuant to the partnership agreement.
Cons. In a general partnership, each partner is jointly and severally responsible for the partnership’s liabilities; this means each partner is responsible for liabilities any of the other partners incurred while acting in the ordinary course of their business. In a limited partnership, there are both general and limited partners; a limited partner does not participate in the business except by contributing capital, and is only liable to the extent of their contribution, not for the liabilities incurred by another partner. Adding other owners can also lead to conflict between them, though a well-drafted partnership agreement can help avoid or resolve disputes.
3. Corporation
A corporation is a legal entity separate from its owners and with all the rights, powers and privileges of a natural person. The owners of the corporation are shareholders, who manage the corporation through the election of directors but are not otherwise entitled to participate in the corporation’s business. Properly structuring and incorporating from the get-go helps avoid disputes, protects the corporation (and the founders) if disputes do come up, and avoids the time and expense of doing it over later – so plan ahead. Here are five of the key considerations to think about before you incorporate: how to structure the shares; a shareholders’ agreement addressing the shareholders’ rights and obligations (highly recommended when forming a corporation with multiple shareholders); a stock option plan; a reverse vesting agreement; and intellectual property matters.
Pros. The shareholders are generally not liable for the debts, obligations or actions of the corporation. There are also several tax advantages to incorporation, especially after a business is profitable. Since a corporation is a separate taxable entity, a shareholder is only taxed on the income that flows to them through dividends or salaries, so a corporation can offer tax deferral by structuring when such dividends are issued. There are also numerous ways to structure a corporation to benefit from available income tax deductions and exemptions. For example, a “Canadian-controlled private corporation” qualifying for the “small business deduction” is typically taxed at a lower rate than that applicable to other corporations up to a designated dollar value of active business income, which varies by province; in N.B. and P.E.I., the rate is less than half for the first $500,000 of active business income. In addition, in 2017, qualified small business corporation shares can allow a shareholder to claim up to $835,715 as a lifetime capital gains exemption on disposition, and there is a similar capital gains exemption of up to $1 million for qualified farm or fishing property. Plus, while your business will likely require capital, and thus financing (usually either debt or equity), to grow, no matter which business structure you’ve chosen, that financing might be easier for a corporation to obtain. Finally, ownership in a corporation is transferable, so incorporation can also be a useful succession planning tool.
Cons. A corporation is the most complex structure, and the most expensive to set up and maintain. The trade-off for these cons is limited, though not absolute, personal liability for shareholders and directors. Corporate directors are still exposed to personal liability under various federal and provincial laws, including: for wages, other payments to employees and unremitted employee wage source deductions; under legislation regarding environmental law breaches; and under industry-specific laws. Both directors and shareholders may also be required to give – and be personally liable for – personal guarantees required to obtain corporate financing. Since shareholders are owners, incorporation also creates the potential for disputes between those owners, though a well-drafted shareholders’ agreement can help avoid or resolve disputes.
Please contact your McInnes Cooper lawyer or any member of the Startup Team @ McInnes Cooper to discuss this topic or any other legal issue.
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