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Corporation, Partnership, Sole Proprietorship - The Basics

In Canada business entities considered by startup 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 startups are organized and operated as privately held partnerships during launch of the business; the partnership form allows angel investors to take advantage of tax losses generated by the venture. Conversion to a corporation may be desirable later in order to facilitate venture financing or 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.

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 a startup must consider a number of factors to determine which method will be most appropriate in each instance. Following are the factors that management of a startup should consider in determining the type of business entity: (1) are the founders 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 transferability 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 founders for the obligations of the startup. 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 management’s liability to the amount of capital invested and isolate personal assets from being used to satisfy the liabilities of the startup.

In evaluating the type of entity to select, transaction costs can be a significant factor. 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 founders of a startup 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 startup (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 founders and can elect to have perpetual existence, subject to the statutory right of the founders to dissolve the business at any time.