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.
Choosing the Legal Structure of Your Business
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)
Tax implications of sole proprietorships
- Personal Income Tax: The business income is not separate from the owner's income. You report all business earnings and expenses on your personal income tax return using Form T2125 (Statement of Business or Professional Activities).
- Tax Rates: Income is taxed at personal income tax rates, which are progressive—the rate increases as income rises.
- Tax Deductions: Business losses can offset other personal income, potentially reducing your overall tax liability.
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:
- 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.
- 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).
- 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
Tax implications of partnerships
- Flow-Through Taxation: The partnership itself doesn't pay income tax. Instead, it files an information return (Form T5013) reporting income and expenses.
- Individual Reporting: Each partner reports their share of the partnership's income or loss on their personal or corporate tax return, according to the partnership agreement.
- Tax Planning Opportunities: Partners can plan individually for tax efficiencies.
- Potential for Higher Taxes: Partners may pay higher taxes at personal rates compared to corporate rates on high incomes.
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
- Separate Legal Entity: A corporation files its own tax return (Form T2) and pays corporate income tax on its profits.
- Corporate Tax Rates: Generally lower than personal tax rates, especially for small businesses eligible for the Small Business Deduction (SBD).
- Small Business Deduction: Applies to Canadian-controlled private corporations (CCPCs) on active business income up to $500,000, reducing the net federal tax rate.
- Dividends and Salaries: Shareholders can receive income through salaries (deductible to the corporation) or dividends (paid from after-tax profits).
Tax implications of incorporating
- Tax Deferral: Ability to defer personal taxes by retaining income within the corporation.
- Income Splitting: Potential to distribute income among family members as shareholders (subject to Tax on Split Income rules).
- Double Taxation: Income can be taxed at both the corporate and personal levels when distributed as dividends, though dividend tax credits can mitigate this.
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).
How to choose the right legal structure for your business
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 three tips will help set your business on the most suitable track:
- 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.
- 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.
- 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.
Specifically, a person planning a new business may consider the following steps in their decision-making:
Step 1: Understand the Types of Legal Structures
Familiarize yourself with the common business structures available in Canada: sole proprietorships, partnerships, and corporations.
Step 2: Assess Business Needs and Goals
Consider the nature of your business and your long-term objectives:
- Size and Scope: Is it a small local business or a venture with plans for significant growth?
- Industry: Certain industries may have preferred or required structures.
- Ownership: Will there be partners or investors if the business begins to grow?
Step 3: Evaluate Liability Considerations
Determine how much personal liability you're willing to assume:
- Sole Proprietorship and Partnership: Owners have unlimited personal liability for business debts and obligations.
- Corporation: Offers limited liability protection; shareholders are typically not personally responsible for corporate debts.
Step 4: Consider Tax Implications
Understand how each structure affects taxation:
- Sole Proprietorship and Partnership:
- Income is reported on personal tax returns.
- Profits are taxed at personal income tax rates.
- Business losses can offset other personal income.
- Corporation:
- Pays corporate tax rates, which may be lower than personal rates.
- Eligible for the Small Business Deduction on active business income up to $500,000.
- Ability to defer personal taxes by retaining earnings within the corporation.
- Potential for income splitting through salaries and dividends (subject to tax rules).
Step 5: Analyze Administrative Responsibilities
Consider the complexity and cost of administration:
- Sole Proprietorship:
- Easiest and least expensive to set up.
- Minimal ongoing regulatory requirements.
- Partnership:
- Requires a partnership agreement.
- Moderate administrative duties.
- Corporation:
- More complex and costly to establish.
- Must maintain corporate records, hold annual meetings, and file separate tax returns.
Step 6: Evaluate Access to Capital
Determine your funding needs and how each structure can meet them:
- Sole Proprietorship and Partnership:
- Funding is typically limited to personal resources and loans.
- Harder to attract investors due to unlimited liability.
- Corporation:
- Easier to raise capital through the sale of shares.
- Attracts investors seeking limited liability.
Step 7: Consider Control and Decision-Making
Decide how much control you want over business decisions:
- Sole Proprietorship:
- Full control over all decisions.
- Partnership:
- Shared control with partners as per the partnership agreement.
- Corporation:
- Managed by a board of directors elected by shareholders.
- Control depends on share ownership.
Step 8: Think About Future Needs
Anticipate how your business may evolve:
- Growth Plans: If you plan to expand significantly, a corporation may be more suitable.
- Exit Strategy: Consider how easy it is to sell or transfer ownership under each structure.
- Succession Planning: Determine how ownership will be passed on in the future.
Step 9: Seek Professional Advice
Consult with legal and financial professionals:
- Lawyer: Can advise on legal implications, liability issues, and help with registration.
- Accountant: Can provide insights on tax implications and financial planning.
- Business Advisor: May offer guidance on strategic considerations and industry norms.
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!
