How to Impress Your Banker

One of the first major decisions you will have to make as you start your new business is the form of legal entity it will take. To a large extent, this decision will depend upon the size and type of business contemplated and the number of people who will manage or finance the business.

The form of entity you choose can have a significant impact on the way you are protected under the law and the way you are affected by income tax rules and regulations. There are three basic forms of business organization. Each structure has advantages and disadvantages and is treated differently for legal and tax purposes.

Sole Proprietorship

A sole proprietorship is typically a business owned and operated by one individual and is one of the most common structures an entity may take. Virtually any business can be carried on in this manner, regardless of the type of operation or number of employees. A sole proprietorship is not considered to be a distinct legal entity under the law, but rather is an extension of the individual who owns it. The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred by the business. The income or loss of a sole proprietorship is combined with the other earnings of an individual for income tax purposes.

Advantages

• Flexible and easy to establish
• Minimal legal restrictions
• Owner has direct control and all profits go to the owner
• Maximum privacy
• Low start up costs and minimal working capital requirements
• Tax advantages may exist for owner
• Can simply discontinue if you wish or easy to change to a different legal structure

Disadvantages

• Unlimited liability for owner; no separation of business and personal assets and liabilities
• No profit distribution you will be taxed on the net income of the business regardless of how much money you are taking out personally
• Difficult to raise capital
• Limitations related to knowledge, skill and capital may exist
• Lack of continuity-business will cease upon death of the owner

Partnership

A partnership can take two legal forms, general or limited. In a general partnership, two or more individuals join together to run the business enterprise. A partnership must usually register with the Provincial authorities. Each of the individual partners has ownership of company assets and responsibility for liabilities, as well as authority in running the business. The rights, responsibilities and obligations of both the limited and general partnership are typically detailed in a partnership agreement. It is a good idea to have such an agreement for any partnership, whether limited or general.

The authority of the partners, and the way in which profits or losses are to be shared should be established in the partnership agreement. The responsibility for liabilities should also be clarified by the agreement among the partners, but partnership creditors typically have recourse to the personal assets of each of the partners for settlement of partnership debts.

A partnership is a legal entity recognized under the law and as such it has rights and responsibilities in and of itself. A partnership can sign contracts, obtain trade credit and borrow money. When a limited partnership is small, most creditors require a personal guarantee of the general partners for credit. A limited partnership is a variation of the general partnership comprised of one or more general partners who are personally liable for partnership debts and one or more limited partners who contribute capital and share in the profits or losses of the business. The limited partners do not take a part in running the business and are not liable for the debts of the partnership.

A partnership of more than five partners must file an information return with CCRA (formerly Revenue Canada) annually. A partnership does not file an income tax return; the information from the information return or financial statements is combined with the personal income of the partner to determine the overall individual partner’s tax liability.

Advantages

• Simply organized; Low startup costs
• Limited outside regulation
• Greater financial strength than proprietorship
• Decision making is divided-an advantage and a disadvantage should there be misunderstandings
• Easy to change the legal structure

Disadvantages

• Both partners may have unlimited liability-depending upon the form of partnership
• Divided authority
• Difficult to raise capital
• Hard to find just the right partner
• Death would dissolve the partnership
  

Corporation

A corporation is a separate legal entity, which exists under the authority granted by Provincial or Federal law. A Corporation has substantially all of the legal rights of an individual and is responsible for its own debts. It must also file income tax returns and pay taxes on income it derives from its operations. The owners of the corporation are the shareholders who may or may not manage the actual business.

Typically, the owners or shareholders of a corporation are protected from the liabilities of the business. However, when a corporation is small, creditors often require personal guarantees of the principal owners before extending credit. The legal protection afforded the owners of a corporation can far outweigh the additional expense of starting and administering a corporation.

Provincial returns must be filed with the province in which the corporation resides and possibly with other provinces in which the corporation does business.

The advice of competent legal counsel and an accountant should be sought if a corporation is the structure that you choose to operate your business.

Advantages

• Individual liability is limited
• Ownership can be easily transferred without any difficulty
• More diverse skill sets and knowledge maybe available
• Separate entity from owners in regards to rights and duties
• Greater financial strength due to increased ability to raise capital
• The business has unlimited life-death of shareholder does not impact corporation
• Possible tax advantages

Disadvantages

• More expensive to organize and administer; additional record keeping required
• Activities are restricted by charter
• Additional regulation
• Less privacy regarding financial and other affairs
• Management maybe subject to restrictions as determined in the memorandum and/or articles of association
• Subject to separate corporate tax system on federal and provincial levels

While the business may begin using one structure over another, the decision is never really final for most businesses. As the business grows and the needs of the business or the owner change, the structure maybe changed to suit the situation.