Do I incorporate or not? How else can I organize my business to satisfy legal requirements? What are the advantages of different types of business structures?
Business structures are chosen for the most part to comply with tax law, which treats each type of structure differently. There are three types of legal structures for a business: sole proprietorship, partnership (which is a form of proprietorship) and incorporation. Each has distinct characteristics. The Canada Business site provides useful information on business structures specific to each province.
A sole proprietorship is informal and easily created and therefore is the most common structure chosen by new businesses. In a sole proprietorship, the business and the operator are the same in the eyes of legal and tax authorities. Tax law treats a sole proprietorship as an income source for the proprietor and therefore requires that the financial details of the business be listed in a separate section of the personal income tax form. In a sole proprietorship, the money and responsibilities of the business are the proprietor's, and vice versa.
This presents some possibilities for tax management on the part of the sole proprietor. If the business generates a loss, it can be applied to reduce income gained from other sources. This is why most part-time businesses are sole proprietorships. Sole proprietorships have a downside, however, in that the proprietor is personally liable for all functions and debts of the business.
A partnership is similar, but instead of one proprietor, there are two or more. As with a sole proprietorship, there is no legal structure for a partnership. However, partners usually have some type of contractual agreement that governs, in percentage terms, the sharing of revenues, expenses and tasks. Then when preparing their taxes, the partners apply the same percentages to income and expenses.
Corporations are more complicated legal structures than proprietorships or partnerships. Incorporation is a process in which a separate legal entity, owned by its shareholders, is formed. Incorporation creates formal ownership shares, which produces a taxation and legal distance between the company and the shareholders. This in turn has tax advantages for the owners, who are usually paid as employees of the corporation. Incorporation provides some liability protection for the corporation's debts, and it offers some measure of protection for a company's name. Company officers and shareholders may come and go, but the corporation exists until it is wound down.
Incorporation is most often done under a charter in the operator's home province, but some companies that operate in many provinces or internationally, or that require enhanced credibility, incorporate federally. This is more expensive and complicated. Corporations must keep meticulous records and report their financial situations to governing authorities yearly. Therefore, their financial statements must be audited annually by qualified accountants.
Because corporations are more costly to operate than sole proprietorships and partnerships, new businesses do not usually incorporate unless they plan to acquire capital through sale of shares, or desire greater credibility. Companies usually do not incorporate until they generate at least $50,000 in revenue annually.
Content in this section is provided in partnership with the Business Development Bank of Canada. BDC provides entrepreneurs with financing, venture capital and consulting services. To find out more go to BDC.ca.
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