When a business is started, it can be structured as a proprietorship,
partnership, or corporation.
Proprietorship
A sole proprietorship
is one person operating a business, without forming a corporation. The
income of the business is then taxed in the hands of the owner (the
proprietor), at personal income tax rates. The income is considered
income from self-employment, and is included on the personal income tax return
of the owner.
Advantages of proprietorship:
Setting up a business in the form of a proprietorship is relatively simple
and the costs are low.
If the business loses money, the losses can be written off against other income of the proprietor.
Proprietorships are less regulated than
corporations. The administration of a proprietorship is less costly
than that of a corporation. However, proprietorships are regulated by
the provincial/territorial governments, and the proprietorship may have
to be registered.
The proprietor is in control of all decision making,
and receives all profits of the business.
Disadvantages of a
proprietorship:
The biggest disadvantage of a proprietorship is
unlimited liability. The proprietor is liable for all debts and other
liabilities of the business. If the business is sued, all the business
and personal
assets of the owner are at risk.
If the business is profitable, it will usually be
paying higher taxes than if it was incorporated as a Canadian
Controlled Private Corporation (CCPC). The lowest personal
income tax rate paid
by a proprietorship would range from 19% to 26% (in 2015),
depending on the province/territory. This rate increases with income.
Taxable income over $138,586 (federally, in 2015) is taxed at the highest marginal rates, which
range from 39% to 54.8%, depending on the province/territory. See the
Marginal Tax Rates page.
A proprietorship has a lack of permanence - if the
owner dies, the net business assets pass to the heirs, but valuable leases
and contracts may not.
Partnership
A partnership is also an unincorporated
business. It is similar to a proprietorship, except two or more entities
are partners in the business. For partners who are individuals, the
income from the partnership is taxed at personal income tax rates,
and a percentage of the income is included on the personal income tax return
of each owner.
Advantages of partnership:
The setup costs of a partnership are relatively
low.
A partnership is less regulated than a corporation. A partnership
agreement should be drawn up to outline the terms of the partnership, what
happens in the event of a dissolution, and what happens in the event of
disagreements among partners. In the absence of an agreement, or if
certain provisions are not addressed in the agreement, provincial or
territorial laws will determine some or all of the terms of the partnership.
Business losses can be written off against other income
of the partners.
Broader base of experience, knowledge and skills to
draw from.
Disadvantages of a partnership:
The biggest disadvantage of a partnership is unlimited
liability. The partners are jointly liable for all debts and other
liabilities of the business. If the business is sued, all the business
and personal
assets of the partners are at risk. An exception to this is a
Limited Partnership. Limited Partners, who contribute capital but do
not participate in the management of the business, will have their liability
limited to the amount of capital that they have contributed. The
partners who participate in the management of the business are called
General Partners, and will still have unlimited liability.
Decisions must be made jointly.
If the business is profitable, it will usually be
paying higher taxes than if it was incorporated as a Canadian
controlled private corporation (CCPC). See this same topic above
under proprietorships.
The death or retirement of a partner will not end the
partner's liability for debts and obligations of the partnership that were
incurred prior to the death or retirement. Also, if a partner retires
and does not make the retirement publicly known, he/she could still be held
liable for obligations incurred by the partnership after the retirement.
Corporation
A corporation is a separate legal entity, which is formed by application to
either the federal government, or one of the provincial/territorial governments. The
corporation issues shares to the owners, or shareholders. The funding of
the corporation can be done through the issue of shares, or by borrowing.
Instead of investing a large amount in shares, shareholders can lend money to the corporation, and invest only a minimal
amount in the shares. This way, when the
corporation has available cash, the shareholder loans can be repaid without
attracting personal income tax.
Being
a separate legal entity, a corporation pays corporate income tax, which is
calculated completely separately from the owners' personal income tax.
If the corporation pays wages to the shareholders, income tax and Canada
Pension Plan contributions, and sometimesEmployment
Insurance premiums, must be deducted and remitted to Canada Revenue
Agency.
Advantages of incorporation:
One of the biggest advantages of incorporating a business
is limited liability. This means that the liability of the shareholders is usually limited to the
amount that they have invested in their shares in the corporation. However, many incorporated small businesses are not able to get bank loans
without the personal guarantee of the shareholders, so this eliminates part of
the advantage of limited liability. The personal assets of the
shareholders are protected from lawsuits against the
corporation. However, shareholders who are directors of the corporation
can be held legally liable for some debts of the corporation (such as GST/HST
and payroll taxes) in certain circumstances.
Another major advantage for a profitable small business
is the income tax advantage. A Canadian controlled private corporation, or
CCPC, pays a much lower rate of
federal tax (small business rate) on the first $500,000 (in 2017) of active business income than would be paid by an unincorporated
business, due to the small business
deduction. Active business income generally does not include investment income
or rental income, which is taxed at regular corporate
tax rates. The combined federal + provincial small business tax
rate varies from
approximately 10.5% to 18.5% in 2017 for the first $500,000, depending on the
province, and from 26% to 31% for income over the threshold. The threshold
amount subject to the lower small business rate also varies between provinces. Keep in mind that
this tax advantage is mainly a deferral of taxes until the profits are paid
out to the shareholder. If all the profits are paid out to the
shareholder as they are earned, leaving the corporation with little or no
taxable income, then they will be taxed entirely as income of the
shareholder, at personal income tax rates.
Another tax advantage of incorporation is the Lifetime
Capital Gains Exemption on the sale of shares of a qualifying
small business corporation. One of the qualifications is that the corporation must be
a CCPC with active business income.
Private Health Service Plans can be
used to provide tax-free benefits to employees. This deduction is also
available to sole proprietors and partners, but the treatment for corporations is more
favourable than that for unincorporated
businesses.
Disadvantages of
incorporation:
Incorporation is the business structure with the
highest setup and administrative costs.
Incorporation is the most complicated business
structure. It is very important to take extreme care in setting up
classes of shares, deciding who will be shareholders (spouses, children)
and how much control they will have (control is determined by % of voting
shares owned). Professional advice can avoid serious problems.
Business losses cannot be written off against other
income of the owners (shareholders).
More administrative work is required for a
corporation. This includes annual reports filed with the corporate
registry, and corporate tax returns which are filed separately from the
owners' personal tax returns.
Generally, the higher the net income of your small business, the more
advantageous it is to incorporate instead of remaining as a proprietorship.
No
matter what the type of business structure, spouses and children can be
employed by the business, thus effectively splitting income. However,
amounts expensed must be reasonable amounts based on services provided, and
must actually be paid to the spouse and/or children.
Each type of business entity has
its advantages and disadvantages. It is wise to seek professional advice to assist in your
decision-making, and in the setting up of your business structure. It is
also very important to get your accounting records set up and organized
properly at the start of your business.
The Canada
Business Service Centres provide information related to starting a
business. There are links to their web sites on our Links
page.
Tax Tip: It is very
important to get your business set up properly - get
professional advice!