3 Common Types of Legal Structure for Businesses

Omar Visram
3 Common Types of Legal Structure for Businesses

Determining your legal structure is an essential first step before you register a new business. The structure you choose will impact everything from how you pay taxes to the level of personal liability you take on.

In this overview of the legal structure of businesses, we’ll compare the three most common types of business entities in Canada (including key advantages and disadvantages) and consider how to choose the right structure for your small business. 

Most businesses in Canada fall into one of three categories: sole proprietorships, partnerships, or corporations.

1. Sole proprietorship

A sole proprietorship is the simplest and least expensive legal structure for businesses with single owners. As a sole proprietor, you’re officially self-employed. That means you assume all the risks of your business and are fully responsible for its legal, financial, and tax obligations. You will report business income and expenses on your personal income tax return using Form T2125 (Statement of Business or Professional Activities).

You'll pay income tax on your net business income at your personal tax rate. Sole proprietors are responsible for covering both the employer and employee portions of Canada Pension Plan (CPP) contributions. You will need to make CPP contributions based on your net business income, which can increase your tax burden. Finally, If your business earns over $30,000 in annual revenue, you must register for and collect GST/HST on sold goods or services. You'll need to remit these taxes to the Canada Revenue Agency (CRA) or Revenue Québec periodically, usually quarterly or annually.

Advantages of a sole proprietorship:

  • You can deduct business expenses from your personal income
  • All business profits go to you
  • You have full decision-making power over your business
  • It’s easy to dissolve your business without any formal paperwork

Disadvantages of a sole proprietorship:

  • You risk losing both business and personal assets if you can’t repay your debts
  • There are no business “shares” to sell as a means to raise capital
  • Your business name isn’t protected (other companies can use it)

2. Partnership

The legal structure of businesses with two or more owners is known as a partnership. Partners share company earnings and losses and make all business decisions together. The partnership does not pay income tax; rather, each partner reports their share of the partnership's income or loss on their personal income tax return. The partnership files a T5013 return to report its income, deductions, and credits, which is used by partners to report their share of partnership income on their T1 personal tax returns.

As is the case with sole proprietors, partners (in a partnership) are responsible for paying both the employer and employee portions of Canada Pension Plan (CPP) contributions on their share of partnership income. They are also responsible for remitting GST/HST if their annual revenues exceed $30,000.

A partnership agreement outlining each partner's rights, responsibilities, and profit-sharing arrangements is a must in Canada. This agreement can also specify how partnership income or losses will be allocated among partners for tax purposes.

There are three main types of partnership agreements in Canada, all of which are relatively easy and inexpensive to set up:

  1. General partnership. You and your general partner(s) co-manage your business. Each of you is personally liable for its debts, obligations, and consequences of one another’s actions.
  2. Limited partnership (LP). Your business has a minimum of one general partner and one limited partner (limited partners are investors only and don’t participate in business management).
  3. Limited liability partnership (LLP). Your personal liability is limited to the amount you put into the business, and you’re not liable for the consequences of other partners’ actions.

Note: Limited liability companies are a US business structure. If you’re looking for a legal structure in Canada that’s similar to a limited liability company (LLC), you should consider a limited partnership or corporation. 

Advantages of a partnership

  • Business debts, liabilities, and losses are all shared
  • Your business isn’t subject to income tax and doesn’t file a return (each partner reports and pays taxes on their share of any income or loss) 
  • You can benefit from the joint efforts, skillsets, and financial borrowing power of multiple partners

Disadvantages of a partnership

  • You must share both profits and responsibility for debts or negligence caused by your partner(s)
  • Finding the right partner can be difficult, and partnership disputes aren’t uncommon
  • Your business name isn’t protected

3. Corporation

The legal structure of businesses held by shareholders is known as a corporation. As independent legal entities, corporations are more complex than partnerships or sole proprietorships.

Incorporating your business generates ownership shares, which creates a legal and tax separation between you (a shareholder) and your corporation. On the upside, paying yourself as a corporate employee has tax advantages. On the downside, corporate income is double-taxed: once when it’s earned and again (in the hands of shareholders) when it’s paid out as dividends.

Advantages of incorporating

  • You’re not personally responsible for your corporation’s debts
  • You can raise capital by selling company shares 
  • Selling your shares makes it easy to transfer business ownership
  • Your business name is legally protected

Disadvantages of incorporating

  • Corporations are carefully regulated and require extensive record-keeping and reporting
  • You can be held liable for your corporation under certain circumstances (like fraud, for example)
  • You must file two separate income tax returns annually: one for you and one for your business

Suppose you decide to incorporate when starting a business. In that case, you’ll also need to choose between incorporating provincially (to conduct business within a single province like BC) or federally (to conduct business in several provinces or outside Canada).

Choosing the right business structure starts with analyzing your company goals and understanding pertinent local, provincial, and federal laws. 

Although the legal structure of businesses can be adjusted as a company grows to meet new demands, these 3 tips will help set your business on the most suitable track:

  1. Compare pros and cons. As you review the main characteristics of the most common business structures, remember that ownership responsibilities, regulations, tax structures, and filing requirements can differ from province to province. 
  2. Contemplate personal liability vs control. How much personal liability are you willing to assume, and how much control over your business do you want? If you’re not comfortable risking your personal assets, for example, you should consider the liability protection that incorporating provides. You should also think carefully about how happy you will or won’t be to have partners, shareholders, or a board of directors sharing in your business decisions.
  3. Consider tax structure. Sole proprietorships and partnerships are based on pass-through taxation, which means you (or you and your partners)—not your business—pay tax on any profits through your personal tax return(s). Corporations are based on a double-taxation system. You should consult with a tax accountant when exploring tax structures. 

Once you’ve chosen the right legal structure for your business, one of your next priorities should be to set up your bookkeeping. No matter which structure you choose, having an accurate, reliable set of books from the start will make it easier to monitor your business’s profits and losses.  

Looking for bookkeeping services tailored directly to your needs as a new business owner? Enkel can help! We provide online bookkeeping services to businesses in Vancouver, Toronto, Calgary, and other cities across Canada. Contact us today to learn more!

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