To Incorporate or not to Incorporate?

To incorporate, or not to incorporate, may be one of the first questions you consider when setting up your new business. Before jumping to the conclusion that you should incorporate your business right out of the gate, you may wish to consider the pros and cons of operating your business (at least for some initial period of time) either as a sole proprietorship, general partnership or limited partnership (among other possibilities).

Some of the key issues to consider in answering this question, include:

1. Liability;
2. Ownership and Control;
3. Financing; and
4. Tax and Estate Planning.

Liability

One of the main advantages of incorporating your business is the limited liability of the corporate structure. A corporation is a distinct legal entity that is separate and apart from its owners (i.e. the shareholders). As a general rule, no shareholder of a corporation is personally liable for the debts, obligations or acts of the corporation. However, directors and officers of the corporation can have some liability for the decisions they make and the things they do (or fail to do) on behalf of the corporation.

A sole proprietorship, on the other hand, is not a legal entity separate from its owner (i.e. the sole proprietor), and thus the sole proprietor is personally liable for all of the debts, obligations and acts of the business (including any wrongs committed by employees in the ordinary course of their employment). All personal assets of the sole proprietor may be seized to satisfy the debts and obligations of the business.

Like a sole proprietorship, a partnership is not a legal entity separate from its partners. The assets and liabilities of the partnership business are considered the assets and liabilities of the partners themselves. Each partner is jointly liable with the other partners for all debts and obligations of the partnership business (incurred while the person is a partner). Partners are also jointly liable for any wrongful acts or omissions of a partner acting in the normal course of the business (thus you should choose your partners wisely).

A limited partnership involves a partnership between at least one limited partner and at least one general partner. Liability of the limited partners is limited solely to what they have invested in the partnership (so long as they do not take part in the control or management of the business), while the general partner (who is responsible for managing the business) faces unlimited liability for all debts and obligations of the business (although personal liability can be minimized by using a corporation as the general partner).

Ownership and Control

As the sole owner of the business, the sole proprietor has absolute control over all decision-making and management of the business.

General partnerships are flexible in matters of ownership and control of the business, as such matters can be determined by the partners themselves in the form of a partnership agreement entered into between the partners. However, in the absence of such a partnership agreement, the ownership and control of a general partnership is governed by default rules under the Ontario Partnerships Act (e.g. each partner has an equal right to take part in the management of the partnership business, and a right to share equally in the capital and profits of the business).

In a limited partnership, the general partner has all of the rights and obligations of a partner in a general partnership (including the right to manage the business). This is subject, however, to the provisions of Ontario’s Limited Partnerships Act requiring the consent of the limited partners for certain actions to be taken by the general partner. A limited partner may not take part in the control or management of the business (as doing so will cause the limited partner to lose his or her limited liability status and be subject to the unlimited liability of a general partner).

In a corporation, the directors have responsibility for managing the business (or at least supervising the management of the business). Officers are appointed by the directors and can only exercise the specific management powers delegated to them by the directors. Ultimately, the shareholders have the power to elect the directors, and the shareholders retain the power to vote on and approve certain fundamental changes to the corporation or its business that are proposed by the directors.

Financing

In a sole proprietorship, available capital is generally limited to the sole proprietor’s assets. Obtaining debt financing from third parties may be difficult for sole proprietors who do not have sufficient personal or business assets to secure a loan.

With a greater number of owners, a partnership structure provides greater opportunity to access funds from the individual partners. Debt financing can also be easier to obtain as lenders can look to the collective assets of all of the partners to secure a loan.

A limited partnership can raise equity capital by attracting passive investors (i.e. limited partners) that are looking for a financial return from the business without the unlimited liability or management responsibility associated with being a partner in a general partnership. The ability to obtain debt financing from third parties will likely depend on the sufficiency of the business assets that such lenders will have recourse to.

Similar to a limited partnership, an incorporated business can attract larger numbers of equity investors (i.e. shareholders) by offering such shareholders limited liability together with an equity interest in the business. By creating different classes of shares (each class having different rights and privileges) opportunities for equity financing can be broadened to appeal to specific investor preferences and demands. Since a corporation owns its own property, lenders can look to the assets of the business as security for the loan (although in practice loans to small businesses often require a personal guarantee from one or more shareholders).

Tax and Estate Planning

Since there is no legal distinction between a sole proprietorship and the owner (i.e. the sole proprietor), the sole proprietor is taxed directly on the income or losses of the sole proprietorship. This allows losses from the business (e.g. incurred during the start-up of the business) to be offset against other sources of personal income, reducing the net income tax otherwise payable. On the other hand, once the business becomes profitable, the business income will be added to any other sources of personal income and taxed at rates that may be higher than the special rates applicable to business corporations. The ability to offset losses against other income often justifies starting and keeping a business as a sole proprietorship until it becomes profitable, at which time it can be converted to a corporation.

Opportunities for estate planning are quite limited for sole proprietorships, since the business will effectively dissolve upon the death of the sole proprietor (unless the business is sold or the business assets are transferred as a going concern by the estate of the deceased).

For general partnerships, business income and losses are calculated at the partnership level, but the partnership itself is not subject to tax. Instead, the income or loss of the business is allocated to, and taxed in the hands of, each individual partner. Because new businesses frequently experience initial losses, the flow-through tax treatment of a general partnership can often benefit the partners by allowing them to immediately apply any losses from the business to offset personal income from other sources. The ability to offset losses against other income often justifies starting and keeping a business as a partnership until it becomes profitable, at which time it can be converted to a corporation.

Since a partnership is not a legal entity separate and apart from its partners, its continued existence is somewhat fragile. Unless the partners have agreed otherwise, the partnership will terminate upon the death or insolvency of any partner.

Limited partnerships generally enjoy the same flow-through tax treatment as a general partnership, however there are additional technical tax rules that may limit the application of business losses under certain circumstances.

The death or bankruptcy of a limited partner will not terminate the limited partnership (provided that there is always at least one limited partner).

However, the retirement, death or incapacity of a general partner, or the dissolution of a corporate general partner, automatically dissolves a limited partnership (unless there is a remaining general partner, in which case the business may continue with the consent of all of the remaining partners if the right to do so is set out in a limited partnership agreement).

Since a corporation is a separate legal entity from its shareholders, it is the only form of business that is taxed directly. This precludes the often beneficial flow-through tax treatment available to partnerships and sole proprietorships, and leads to a second level of taxation when profits are ultimately distributed to the shareholders by way of dividends. On the other hand, if the business is profitable and the profits are retained in the corporation (rather than distributed to the shareholders), corporate tax rates are generally lower than the personal tax rates applicable to individual partners or sole proprietors. Also, shareholders may take advantage of their lifetime capital gains exemption when the business is sold (provided that the sale is structured as a sale of the shares of the corporation and such shares qualify for tax purposes as “qualified small business corporation shares”)

Since a corporation is a separate legal entity, it continues to exist notwithstanding the death or withdrawal of a shareholder or director. Corporate structures offer a great deal of flexibility when it comes to estate planning. For example, by tailoring the rights and privileges of different classes of shares, a principal shareholder may be able to maintain control over the business while allowing the growth in value of the business to accrue to successive generations.