By Munish Mehta
It is no secret that Canadians have been caught up in the start-up culture that has emerged across various industries.
According to Innovation, Science and Economic Development Canada’s small business statistics, there are just over 1 million small businesses across the country, which employ approximately 8.2 million people that constitute 70.5 percent of private sector employment.
Within Canada, the proportion of businesses that are high-growth enterprises is 7.4 percent (based on revenues). Rapid growth and access to technology has enabled Canadians to think outside the box and to develop new products and services that improve the lives of Canadians. Entrepreneurs are working with their start-ups on either a full-time basis, or part-time basis while continuing their current employment.
Entrepreneurs are initially concerned with funding, gathering information and understanding how to market their product or service. However, another aspect that entrepreneurs must consider is the appropriate business structure for their start-up. The three most common business structures are sole proprietorships, partnerships and corporations.
Sole proprietorships are formed, intentionally or by default, when an individual starts to operate a business without any other legal structure in place. A sole proprietorship is carried on by a single individual.
A partnership is an economic activity carried by two or more individuals with the expectation of earning profit. The obvious difference between those two business structures is the number of individuals who are involved in the business. It is possible for either of them to exist, even without formal registration. That being said, a business name will have to be registered if the business is carried on using a name different from the names of its owners.
On the other hand, a corporation is a separate entity with formal legal requirements. This is a crucial difference between a corporation and the two less formal business structures mentioned above.
Anyone who wishes to carry on a business through a corporation is required to file articles of incorporation with the government’s corporate registry to form a corporation. A corporation can be registered provincially or federally. For example, a for-profit business that will operate primarily in Ontario will register under the Ontario Business Corporations Act (“OBCA”), while one that will operate in various jurisdictions across Canada would likely incorporate under the Canada Business Corporations Act (“CBCA”). A corporation may also be required to register extraprovincially, if it carries on business in a province other than the province in which it is incorporated.
When making a decision on whether to incorporate, there are many issues to consider across a broad range of factors.
In considering the issues, you will need to consult with an advisor in areas such as law, tax and other disciplines, as required based on the specific circumstances of the proposed business venture.
That being said, there are some broad considerations that must be addressed as a preliminary matter, which include liability, tax and structural implications distinct to a corporation.
Starting a business is a risky endeavour. Start-ups often fail or, if they succeed, have difficulty growing in the first few years of business. Start-ups heavily rely on the support and collaboration with investors, suppliers and creditors. However, many entrepreneurs are reluctant to leverage their personal assets to finance initial business expenses. A sole proprietor has unlimited personal liability for the debts and obligations related to the business. For partners, that exposure applies to each partner and each is liable for the obligations of the business received by each of their partners.
One of the benefits of incorporating a business is that it limits the liability to the individual owner (called a shareholder). A corporation is a separate legal entity. A corporation can apply for loans, own assets, issue equity or otherwise enter into contracts for which it is legally responsible. If a claim arises, a claimant must seek recourse directly from the corporation. This shields shareholders personally from such claims. If a corporation loses value, shareholders will likely not lose more than their investment. A shareholder would not be liable for a corporation’s debt unless the shareholder, for example, provides a personal guarantee.
Another major difference is that business income is taxed as part of the sole proprietor’s or partner’s personal income while the corporation is a separate tax payer for the business income.
Furthermore, corporations often enjoy a lower tax rate and have opportunities to defer tax. The Canadian government incentivizes some corporations with lower tax rates in order to promote business venture and activity. For example, the small business deduction is a valuable tax savings measure for new businesses. The small business deduction can reduce the federal tax rate on the first $500,000 of active business income each year to approximately 10 percent for a Canadian-controlled private corporation (CCPC). This encourages corporations to retain and reinvest the income saved from taxes on active business assets, such as equipment, which can help generate growth and create new jobs.
The tax implications for each corporation is different and can change. For example, the government recently proposed changes to the rules for taxing passive business income, which may gradually eliminate the benefit of the small business tax rate on active business income based on the amount of passive investment income a corporation earns. These changes may even cause entrepreneurs to defer incorporating a business and continue with a sole proprietorship or partnership. Accordingly, it is best to consult a tax advisor to determine if incorporating is an appropriate tax-saving strategy for the business.
Another benefit of incorporation is that it assists a business in setting out the parameters for its corporate structure and management. The process of organizing the corporation is usually done in conjunction with incorporation. For example, the initial organization of the corporation includes appointing the corporation’s directors, officers, accountants, and establishing a date for the corporation’s fiscal year end.
Additionally, the corporation will adopt bylaws that set out, for example, the term and role of the directors and officers, the procedure for shareholder and director meetings, and protocols for the conduct of the affairs of the corporation. The by-laws can be revisited and amended from time to time. As a separate legal entity, a corporation can continue indefinitely, regardless of the changes in the corporation’s directors and shareholders.
Also, annual shareholder meetings for the corporation’s shareholders and directors are mandatory under the CBCA and OBCA. The meetings provide an appropriate opportunity for shareholders to approve financial statements and analyze the economic strength of the business. Shareholders can also elect new directors at an annual meeting.
The above-mentioned implications are not meant to be an exhaustive list of considerations when deciding whether it is beneficial or the right time to incorporate.
For example, incorporating can offer flexibility in financing. If the business requires costly assets for their operations, entrepreneurs should consider the benefits of applying for loans or raising equity through a corporation. Furthermore, sole proprietors and partners might determine that it is a good idea to implement a rollover by transferring their business assets to a corporation.
That being said, entrepreneurs would need tax advice to get a better understanding of the benefits of a rollover.
When starting a business, entrepreneurs should carefully assess which business structure is appropriate for accomplishing their business goals and objectives. Accordingly, it is best for entrepreneurs to consult with a legal advisor to fully understand which business structure will most benefit their business.