When you run your business venture as a sole proprietor, you are the business. In essence, you and your business are one and the same - you control all decisions. Any profits or losses are attributed to you personally. You file one tax return because all the income is yours. The business income is considered income from self-employment and is therefore taxed at personal income tax rates. This is true whether you use your name or a business name.
A partnership is similar to a proprietorship, except two or more entities are partners in the business. When you enter into an agreement with another party to do business together, you are acting in partnership with one another which will outline the terms of the partner’s relationship and identifies how the business will be managed. The business is operated as if it were one person behind the operation and all decisions are made jointly.
There is additional exposure with partnerships, as compared to proprietorships, since you may be held liable for the actions of your partner. Partnership liability is joint and several with your partners. This means you are completely liable for everything each of you own, owe, do and have done, whether you are involved or not.
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 partner
The effect of incorporating a business is to create a legal entity distinct from its owners. In law, a “person” may include both a natural person and an artificial person such as a corporation. A significant consequence of being able to create an entity separate from yourself for legal purposes is that the owner is free from any personal obligations to contribute to the corporation’s debts and liabilities.
Generally speaking, there have been two main reasons for incorporating businesses. Firstly, there is the concept of limited liability which is of paramount importance because it enables business owners to place their homes and personal belongings beyond the reach of creditors of the business. Another main reason for incorporating has been to secure tax advantages.
The primary disadvantages of incorporating have to do with the cost of incorporating and the compliance with various government regulation of corporate activity.
1. Limited Liability
Any individual may carry on a business as a sole proprietor. If you choose this structure, you must be prepared to accept all of the risks incidental to your business because you are personally liable to the full extent of your property for all liabilities incurred in the conduct of the business, including any wrongful acts of your employees. You have unlimited exposure to liability.
In a partnership, the partners are jointly liable for all debts and liabilities of the business. If the business is sued, all the business and personal assets of each partner 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 invested. The partners who manage the business are called General Partners and have unlimited liability.
The main advantage to incorporating is the limited liability of the incorporated company. As mentioned, a corporation, unlike a sole proprietorship, has a separate legal existence apart from its shareholders. The corporation, not the shareholders, owns the assets of the business and it is the corporation, not the shareholders, that is subject to whatever liabilities might be incurred. A shareholder’s liability is limited to her investment.
2. Corporate Status
The incorporation of a company brings into being an entirely separate legal entity with defined powers, duties and rules of procedure. The assets and liabilities of the business will lie with the company and are distinct from the assets and liabilities of the persons who own the shares of the company. Because of this, a corporation has an unlimited life span; the corporation will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes.
A proprietorship, however, has a lack of permanence - if the owner dies, the business assets pass to the heirs, but valuable leases and contracts may not. With partnerships, 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.
3. Borrowing Money & Raising Capital Is Easier
A company’s ability to create a floating charge over its assets enables it to offer a form of security not normally available to individuals and proprietors.
Further, corporations have more ability to raise money, which may make it easier for your business to grow and develop. While proprietors and partners can also borrow and incur debt like a corporation, only a corporation can sell shares and raise equity capital, thereby creating a huge advantage because equity capital generally does not have to be repaid and incurs no interest. Of course, by issuing shares to third parties, you dilute your ownership in the company.
The ability to issue shares to third parties leads into the next two advantages of incorporating flexibility and control.
The minimal denominations in which shares can be issued, the ease and simplicity with which the ownership of such shares can be transferred and, above all, the variety of capital structures available to companies provide for considerable flexibility. The rights attaching to shares can be arranged to suit individual needs, thus allowing greater flexibility in estate planning, employee participation schemes, shareholdings in other corporations, mergers, reorganizations, etc.
If your business is successful you may have commercial, family or other reasons to divest yourself of the ownership of part of your business, allowing you to realize part of the value of the business while still retaining control over it.
As the ownership of a company is represented by shares it is very easy to sell a portion of a company simply by selling a certain number of shares to third parties. By retaining 51% of the shares, the owner can dispose of nearly half her interest while still retaining control of the company. By the use of non-voting shares she can retain control while disposing of the major part in value of her interest.
Neither proprietorship nor partnership can rely on the advantages of flexibility and control as neither structure is formed on a “share capital” model.
6. Tax Advantages to Incorporation
Incorporation provides for certain tax advantages through deferral of tax, income splitting and levelling of income level fluctuations.
(a) Tax Deferral
The Income Tax Act allows corporations to defer paying some tax until a later time, so you may be able to realize tax savings when you are in a lower tax bracket, or if the tax rates have fallen.
Also, income tax rates are lower for corporate income than for personal income. Corporate tax is imposed at the combined Federal and Provincial rate of 13% in Saskatchewan on the first $500,000.00 of a small business’ income (27% after $500,000). To the extent that a proprietor or a partners personal tax rate exceeds 13% there will be an advantage to incorporation since less tax would be payable by the corporation. However, additional tax is payable when dividends are paid by the corporation to its shareholders. As a result, if a shareholder takes all after tax income out of the company each year there will be no deferral advantage.
(b) Income Splitting
The term “income splitting” in this context refers to the organization of income of a company so as to reduce the total tax burden by having the income earned by several individuals rather than one person. For example, rather than have income earned by a taxpayer who has a personal marginal rate of tax of 44%, less tax would be paid on that income if the individual’s spouse or children who each have personal marginal tax rates of 26% earned some of that income.
One method of income splitting that has been commonly used is to distribute the corporate shares to family members. After-tax corporate income could be distributed by way of dividends to the shareholders. A shareholder does not have to be actively involved in the corporation’s business activities to receive dividends. Lower taxes will be paid on such income if the other family members fall in lower tax brackets than the original taxpayer.
(c) Minimization of Income Level Fluctuation
If the profits of your business are subject to annual fluctuations, the use of a corporation would allow you to minimize the effect of such fluctuations on your personal income. You would be able to control the distribution of after-tax corporate earnings. Instead of getting your income when it is received (as is the case with proprietorship), being incorporated allows you to report your income at a time when you will pay less tax.
1. Tax Returns
When you incorporate, you will have to file two tax returns each year, one for your personal income, and one for the corporation. This, of course, will mean increased accounting fees. And as I will mention later, unlike a sole proprietorship or partnership, corporate losses cannot be deducted from the personal income of the owner.
2. Disclosure of Information
There is a lot more paperwork involved in maintaining a corporation than a sole proprietorship or partnership. The Business Corporations Act (Saskatchewan) obliges all corporations to register and disclose certain details of their affairs at the Corporate Registry where they may be inspected by creditors, competitors or the public at large. Corporations must maintain a minute book, containing the corporate bylaws and minutes from corporate meetings.
Proprietorships are less regulated than corporations, however they are somewhat regulated by the provincial/territorial governments, and the proprietorship may have to be registered (i.e., business name).
A partnership is also 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 or disagreements among partners. In the absence of an agreement, or if certain provisions are not addressed in the agreement, provincial laws will determine the terms of the partnership.
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 and how much control they will have. Seeking professional advice can avoid serious problems. Corporations involve additional time and expense in establishment and regular reporting and maintenance of the corporate entity itself, including the preparation of separate and more complicated tax returns.
In comparison, setting up a business in the form of a proprietorship or partnership is relatively simple, the costs are low and the time commitments for ongoing maintenance are minimal.
4. No Personal Tax Credits
Corporations are not eligible for personal tax credits. Every dollar a corporation earned is taxed. As a sole proprietor or a partner, you may be able to claim tax credits a corporation could not.
5. Less Tax Flexibility
As a sole proprietor, you could use the business losses to reduce other types of personal income earned in the year the losses occur. The same advantage applies to partnerships - Business losses can be written off against other income of the partners.
In a corporation, however, these losses cannot be written off against the income of the owners – they can only be carried forward or back to reduce the corporation’s income from other years.
6. Liability May Not Be As Limited As You Think
The prime advantage of incorporating, limited liability, may be undercut by personal guarantees. When a corporation has insufficient assets to secure a loan, the lenders often insist on personal guarantees from the business owner. So although technically the corporation has limited liability, the owner still ends up being personally liable if the corporation cannot meet its debt obligations.
7. Additional Start-up and Ongoing Expenses
Corporations are more expensive to set up. A corporation is a more complex legal structure than a sole proprietorship or partnership, so it is logical that creating one would be more complicated and costly. Legal fees are approximately $1,000 plus disbursements for simple incorporations.
The largest ongoing cost would be for accountant’s fees. While it is not mandatory to have accountants prepare financial statements for a private corporation it is often desirable to ensure proper accounting procedures are involved.
The administration of a proprietorship or a partnership is less costly than that of a corporation. However, successful proprietorships and partnerships should also have such financial statements prepared.
In conclusion the primary advantage to incorporating your business is the protection from personal liability. Your liability will be limited to the assets owned by the corporation and you will receive personal protection for liability arising from contracts, leases, uninsured risks, creditors and suppliers. There are also the advantages of greater flexibility and control allowed by ownership of shares in a corporation rather than ownership of the assets of a sole proprietorship. The ability to defer tax, split income and level out income fluctuations for tax purposes are also of benefit.
On the other hand the primary disadvantages of incorporation are the cost and the increased formalities required of a corporation in complying with government regulations for reporting information.
While every case must be judged on its own facts, a few general conclusions can be drawn. The relative importance of the advantages and disadvantages will vary according to the size of the business. Generally, the higher the net income of your small business, the more advantageous it is to incorporate instead of remaining a proprietor.
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.
|Sole proprietorship or partnership: Is it right for you?|
|You will be the sole owner or own the business with just a few partners or family members.|
|You plan to start the business using only personal savings or investments from friends and family.|
|You expect business revenues to support only you and your partners or family members.|
|You plan to do most of the work yourself.|
|You will borrow personally on behalf of the business.|
|You are in a low personal income tax bracket.|
|Your business is highly unlikely to face a lawsuit or get into debt.|
|You have limited net worth (personal assets).|
|*If you answered yes to most of these questions, you should operate your business as a sole proprietorship or partnership.|
|Corporation: Is it right for you?|
|Ownership will be divided among several shareholders|
|You expect significant start-up costs.|
|You will be hiring employees and paying out wages and salaries.|
|You will require additional financing beyond savings and investments from family and friends.|
|You expect increasing revenues and a rising asset base.|
|You will probably need to raise equity or issue debt, either now or later.|
|You will put a full management and organizational structure in place.|
|You expect to look into income-splitting and tax-deferral options.|
|You want to protect your existing substantial net worth.|
|*If you answered yes to most of these questions, you should operate your business as a corporation.|