If you have an entrepreneurial idea and are ready to start your business, the first step is to choose a business structure. This decision is important because the chosen type of business entity will define how much you pay in taxes, how much paperwork your business is required to do, the personal liability you face and your ability to raise funds.
The best choice will depend on various factors including your preference for the degree of personal liability, tax treatment, leadership and management flexibility, and business compliance complexity.
The most popular types of business structure are Sole Proprietor, Partnership, and Corporation. Although there are no simple rules for selecting which will be right for your case, some questions to consider include:
- Do you want to limit your liability?
- How many people are involved with the business and what are their roles?
- Are there outside investors?
- Do you have any personal assets you wish to keep separate from the business?
- What is your budget for formation and ongoing administration?
- Are you prepared to pay the additional accounting fees required by corporations?
- How much profit is the business expected to generate?
- Will you be re-investing profits in the business, or do you want to take all profits as personal salary?
A sole proprietorship is the most common form of business organization. It’s easy to form and offers complete managerial control to the owner. This usually involves just one individual who owns and operates the entire enterprise. If you intend to work alone, this may be a good option. There are a few disadvantages to consider, however. Selecting the sole proprietorship as your business structure means you’re personally liable for your company’s liabilities. As a result, you’re placing your own assets at risk, and they could be seized to satisfy a business debt or legal claim filed against you.
Raising money for a sole proprietorship can also be difficult. Banks and other financing sources are reluctant to make business loans to sole proprietorships. In most cases, you’ll have to depend on your own financing sources, such as savings, home equity or family loans.
A partnership involves two or more people who agree to share in the profits or losses of a business. A key advantage is that the partnership does not bear the tax burden of profits or the benefit of losses-profits or losses are “passed through” to partners to report on their individual income tax returns. A primary disadvantage is liability-each partner is personally liable for the financial obligations of the business.
So, if your business will be owned and operated by several individuals (“partners”) you’ll want to take a look at structuring your business as a partnership. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership’s debts and other obligations. A limited partnership has both general and limited partners, where the general partners own and operate the business and assume liability for the partnership, and the limited partners serve as investors only. Limited partners have no control over the company and are not subject to the same liabilities as the general partners.
A corporation is a legal entity that is separate from its owners. Like a person, the corporation can be taxed and can be held legally liable for its actions. The key benefit of corporate status is the avoidance of personal liability. The primary disadvantage is the cost to form a corporation and the extensive record-keeping that’s required.
Using the corporate structure is more complex and expensive than most other business structures. The biggest benefit for an entrepreneur who decides to incorporate is the liability protection he or she receives. A corporation’s debt is not considered that of its owners, so if you organize your business as a corporation, you’re not putting your personal assets at risk. A corporation also can retain some of its profits, without the owner paying tax on them.
Another plus is the ability of a corporation to raise money. A corporation can sell shares to raise funds. Corporations also continue indefinitely, even if one of the shareholders dies, sells the shares or becomes disabled. A Corporation is the entity generally preferred by outside institutional investors who might be unable to invest in a Partnership.
This corporate structure, however, comes with some drawbacks. Owners of the corporation pay a double tax on the business’s earnings. Not only are corporations subject to corporate income tax at both the federal and provincial levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.
Considering the above, you have to investigate the different options and decide what makes the most sense for your business. If you have any questions on where to incorporate, please contact our office. We may be able to assist in making an informed decision.