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Choice of Business Entity for Canadian Startup

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Choice of Business Entity for Canadian Startup

Postby Pinskylaw.ca » 01 Dec 2015, 14:32

In Canada business entities considered by entrepreneurs include: (1) sole proprietorships, (2) partnerships and limited partnerships and (3) corporations. Each of these entities has advantages as well as disadvantages. Choice of the entity is usually not irrevocable, and often an initial decision will be made with the understanding that, at the appropriate time, a different form of organization will be used. For example, many start-up enterprises are organized and operated as privately held partnerships during the development stage of the business; the partnership form allows investors to take advantage of tax losses generated by the venture. Conversion to a corporate entity may be desirable later in order to facilitate an initial public offering and to provide other characteristics more appropriate to a publicly held entity, such as limited liability for owners, a centralized management structure, and continuity of existence. However, mistaken tax or business planning may make a change of entity very difficult. Normally, a sole proprietorship can be easily changed into a corporate entity at a later date; changing from the corporate form into a sole proprietorship or a partnership can involve complicated tax and other issues.

1. Factors

Almost all commercial activities in Ontario are carried on using one of the four legal arrangements mentioned above. No one method is best in every case and entrepreneurs must consider a number of factors to determine which method will be most appropriate in each instance. Following are the factors that entrepreneurs consider in determining the type of business entity: (1) are the owners subject to personal liability; (2) what are the costs involved in establishing and operating the entity; (3) how is the entity taxed; (4) how flexible are control mechanisms; (5) what are the considerations determining ransferability of ownership interests; (6) what is the continuity of existence of the entity; (7) citizenship of directors; (8) potential future financing. The different business entities vary greatly with respect to these factors.

In selecting a form of business entity, a primary concern should be the personal liability of owners for the obligations of the business. A corporation is an entity separate and distinct from its shareholders. It is the corporation that owns and operates the business and incurs the liabilities. In contrast, each partner is a part owner of the partnership assets, and a sole proprietor is also the owner of the assets used in the business. A sole proprietor and partners are liable to the full extent of their personal assets for the liabilities of their businesses. A shareholder’s liability to creditors of a corporation is limited to the amount of his or her investment. Therefore, if a substantial uninsurable risk is possible, a corporation is the preferable to limit the entrepreneur’s liability to the amount of capital invested and isolate personal assets from being used to satisfy the liabilities of the business. It should be noted, however, that creditors often require that the owners of small businesses personally guarantee loans made to the businesses, thereby expanding an owner's liability. Moreover, an owner in any type of business does not have limited liability for his own tortious conduct; that owner is liable as an individual tortfeasor. A limited partnership has special uses usually related to taxes, and differs from an ordinary partnership in that there is a limit to the partner’s liability. A limited partner is more akin to a shareholder, while the managing partner of a limited partnership (the general partner) has unlimited liability.

In evaluating the type of entity to select, transaction costs can be a significant factor to entrepreneurs. Business entities differ considerably in the costs required to create and operate them. Some forms of businesses, such as a sole proprietorship or a simple general partnership, have no or low start-up costs and are very inexpensive to establish and run. In contrast, other business entities, such as corporations and limited partnerships, entail greater costs. Preparation of or amendments to a carefully drawn partnership agreement may cost as much in legal fees as the incorporation of a corporation or the execution of corporate amendments.

Taxation plays a major role in selecting the form of business. Sole proprietorships and partnerships are not considered to be separate taxable entities, and taxation is on a "pass-through" basis. In these cases, the income of the business is distributed to the owners. The owners are taxed on this amount of income, and it is the owners who must pay taxes on income of the business whether or not they actually receive the income. Losses receive similar treatment and, subject to certain limitations, can be used to offset an owner's other income. In contrast, corporations are considered separate tax entities and are directly taxed. When such an entity distributes income to its owners, that income is taxed again to the owner. Thus, these funds are taxed twice: once to the entity and once to the owners. The recent creation of a specialized type of flow through trust for tax purposes is a recent innovation in Canadian tax law.

Flexibility of control refers to the extent to which the owners can control the conduct of the business. Partnerships provide considerable latitude to structure the arrangement between parties. In contrast, many of the rules governing the relationship between shareholders are mandatory. Yet, the ability to include in the articles of incorporation provisions that may be limited in by-laws and the availability of the unanimous shareholder agreement can provide considerable flexibility for structuring arrangements between shareholders. The level and degree of control is an extremely important factor that entrepreneurs should not overlook when considering the type of business they want to create.

The extent to which ownership interests may be transferred is an important factor affecting the liquidity of the owners' interests. An ownership interest in a business includes the right to share in the profits of the business (the financial interest) and the right to participate in the management of the business (the management interest). In general and limited partnerships the owners may freely transfer their financial interest but may not transfer their management interest without the consent of all of the other owners. Corporations allow a free transferability of entire ownership interest. Also, sole proprietorships and general partnerships have a limited number of owners a business can have.

Continuity of existence refers to duration of the business entity and whether it can survive changes in ownership. Unless there are provisions to the contrary in a partnership agreement, death or disagreement amongst the partners can result in the dissolution of the partnership, which in turn necessitates renegotiating contracts, filing a notice of the dissolution and a new partnership declaration, entering into a new agreement and providing for new bank signing authorities. The dislocation of a business on the death of a partner or a sole proprietor can very serious. Corporations have high continuity and are not affected by the death, bankruptcy, or withdrawal of owners and can elect to have perpetual existence, subject to the statutory right of the owners to dissolve the business at any time.

There are certain citizenship requirements for directors of corporations incorporated under provincial and federal legislation. Ontario Business Corporations Act (OBCA) requires a majority of the directors of a corporation established in Ontario to be resident Canadians. In contrast Canada Business Corporations Act (CBCA) provides that only 25% of the directors need to be resident Canadians. Unless entrepreneurs are willing to accept these citizenship requirements for directors, it will be necessary to proceed by way of partnership or to incorporate in a province without such citizenship requirement.

Finally, for high-tech start-ups another significant factor applies - potential future financing. The types and sources of financing that will be used for a business can impact its structure. If a business intends obtain financing through common equity and simple debt funding such a business could be organized as a limited partnership, whereas an incorporation will be required when investors are given preferred equity interests. As discussed below, future financing effectively limits the choice for entrepreneurs to incorporation. The income trust is a new commercially accepted organization which must also be considered.

2. Sole Proprietorships

The simplest form of business association is the sole proprietorship. A sole proprietorship exists whenever an individual carries on business for individual’s own account without using the medium of any other form of business organization or involving the participation of other individuals, except as employees. The individual may employ others in the business but cannot employ himself or herself. Any liabilities that arise from tortiuous acts of the sole proprietor or employees of the sole proprietor are the sole proprietor’s responsibility. All business and personal assets of the sole proprietor may be seized in fulfillment of the sole proprietor’s business obligations and liabilities, including debts incurred by the sole proprietor in connection with the business.

The costs in establishing and running a sole proprietorship are minimal; it is formed without any formality. The profits from the business are taxed to the individual owner and filed on the individual's tax returns. Individuals are taxed at progressive rates which, when combined with the tax rates imposed by Ontario, reach maximum rate of 46.4%. The business is freely transferable by sale, gift or will. Finally, the sole proprietorship may have a relatively short life span because the death of the sole proprietor dissolves the sole proprietorship. Typically, the sole proprietorship is used for small family businesses.

3. Partnerships

When two or more persons, whether individuals or corporations, carry on business together with a view to profit, the relationship is called a partnership. A partnership is like a sole proprietorship in that the partners carry on the business themselves directly. The partnership is not a legal entity separate from its partners. There are two forms of partnerships - general partnerships and limited partnerships. A general partnership (normally just called a partnership) is an unincorporated business entity that is formed when two or more persons join together to carry on business with a view to profit. No formal agreement is necessary to create a general partnership. The only formal registration required is a registration of the name of a partnership under the Business Names Act. Thus, if two or more people conduct a business, under normal circumstances a general partnership will result by default. Each partner is liable with the other partners for all debts and obligations of the firm incurred while a partner. The cost to create and run a general partnership depends on the complexity of the partnership arrangement.

A general partnership is not a separate taxable entity. Consequently, the taxation of a general partnership is comparable to a sole proprietorship as the profits and losses "pass-through" to the general partners. Income allocated to the partners is subject to the personal taxation. A general partnership is very flexible in that the management responsibilities can be divided among the partners in virtually any way the partners agree. In the absence of a specific agreement, each partner has an equal right to control of the partnership. Partners may assign their financial interest in the partnership, but the assignee may become a member of the partnership only if all of the members consent. Finally, unless specific provisions are made in the partnership agreement, the death, bankruptcy, or withdrawal of a partner dissolves the general partnership.

Each partner of a general partnership is liable with the other partners to the full extent of his or her personal assets for all debts and obligations incurred while a partner. In the case of tortiuous liability, a partnership is liable, and each partner is jointly and severally liable, to the same extent as the wrongdoing partner for any penalty, loss or injury caused to a non-partner by an act or omission of a partner. A partner is not liable to the creditors of a partnership for anything done before he or she became a partner. A retired partner remains liable for partnership debts or obligations incurred before retirement.

In contrast to the informal creation of a general partnership, which is formed whenever persons or entities carry on business in common with a view to profit, a limited partnership is created by complying with the relevant provisions of the Limited Partnerships Act. A limited partnership is established by filing a declaration of a limited partnership with the Registrar of Partnerships. A declaration expires every five years but may be renewed by filing a new declaration before the expiry date. The limited partnership is a creation of a provincial statute, and the members of the limited partnership must strictly comply with the provincial laws. A limited partnership must have at least one general partner and one limited partner. While general partners have unlimited personal liability for the partnership's obligations, a limited partner must be basically a passive investor rather than an active participant in the operation of the limited partnership and to have limited liability. The costs of creating and managing a limited partnership will typically be more expensive than a general partnership.

Each general partner has an equal right to control of the partnership, whereas limited partners have no right to participate in control. Partners may assign their financial interest in the partnership, but the assignee may become a limited partner only if all of the members consent. Unless otherwise agreed, a limited partnership must dissolve if a general partner dies, goes bankrupt, or withdraws. The limited partnership will survive the death, bankruptcy, or withdrawal of a limited partner. As in the case of a general partnership, a limited partnership is not a separate taxable entity, the income or loss of the business carried on by the partnership is determined on by the partnership and then allocated to the partners. Limited partnerships are frequently used to raise capital and to bring together passive investors with managerial talent. Usually the general partner of the limited partnership is a corporation.

4. Corporations

A corporation with share capital is the business entity used most frequently to carry on commercial activities. A corporation has a separate legal existence apart from its owners. Therefore, if a substantial uninsurable risk is possible, a corporation is the preferable vehicle to limit the entrepreneur’s liability to the amount of capital he or she has invested in a corporation. A corporation may be incorporated under either federal (CBCA) or provincial legislation (OBCA). A corporation is created by filing articles of incorporation with the appropriate provincial or federal office. Federal and provincial corporate laws are similar and the decision as to which jurisdiction to incorporate in depends on the wishes of the incorporators. If an entrepreneur intends to carry on business across Canada, than federal incorporation is preferred. If provincial incorporation is chosen it will generally be necessary to obtain a licence in each of the provinces in which a corporation intends to carry on business (other than the one in which the subsidiary was incorporated). It is possible to change the jurisdiction later since a corporation may transfer from one jurisdiction to another provided that certain procedures are followed.

The OBCA requires a majority of the directors to be resident Canadians, provided that if the corporation has only one or two directors, that director or one of the two directors must be resident Canadian. In contrast, the CBCA provides that, subject to certain exceptions, only 25% of the directors need to be resident Canadians, provided that if the corporation has fewer than four directors, one director must be a resident Canadian. Unless businesses that are owned by foreign entrepreneurs are able and willing to accept the citizenship requirements for directors, it will be necessary either to proceed by way of partnership or to incorporate in a province without such citizenship requirement (Nova Scotia).

A board of directors elected by the shareholders manages the corporation but the board normally delegates to certain officers the oversight of day-to-day activities. Owners are not liable for the actions of the corporation. However, under certain circumstances, the courts will strip away the corporation's protective shield and expose the owners to liability. Courts will "pierce the corporate veil" in extreme cases where shareholders do not follow corporate formalities or intentionally undercapitalize a corporation. The costs of creating and running a corporation may be significant depending upon the complexity of the corporation's organizational documents. The cost often exceed the cost of creating and maintaining a partnership or a limited partnership, and will almost always exceed such costs associated with a sole proprietorship. A corporation is a more formal entity that requires many administrative tasks such as regular board meetings, shareholder votes, and other corporate governance formalities. There are substantial advantages, however, to selecting the corporate form of business. Corporate structures permit the creation of sophisticated financial structures in which variable ownership classes are entitled to different rights and preferences. Also, without shareholder agreements restricting transfers, an ownership interest is freely transferable. Finally, the corporation's existence can be perpetual.

The income or loss of a business carried on by a corporation is both computed and subject to tax at the level of the corporation. When a corporation’s after tax income is distributed to its shareholders by the payment of dividends, these dividends are generally taxed again at the shareholders’ level. There is one very important instance in which less immediate tax will be paid if a business is carried on through a corporation rather than on an unincorporated basis – where the business is carried on by a Canadian-controlled Private Corporation (CCPC). A CCPC in Ontario is taxed at about one half the regular rate on the first $300,000 of active business income each year. If a corporation is not eligible for the small business deduction, there is still an advantage from a tax standpoint to carry on the business through a corporation rather than as a sole proprietorship or partnership. An individual proprietor or partner is taxed at marginal rates of up to 46.4%, while a corporation is taxed at a flat rate of about 36.1% on its first dollar of income. If all income earned by the corporation is paid out in the form of salary, the corporation will pay no income tax. The shareholders will thus be taxed at the same rate as if they had earned the income through a sole proprietorship or a partnership.
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