Choosing the Right Corporate Structure

One of the most important decisions in the early stages of a new business is choosing the proper corporate structure.  The chosen structure not only impacts liability, taxes and reporting for the business, but it may also have a significant impact in the execution of a business strategy.  It is never too early to establish a business plan and choose the corporate structure.  It is also important to revisit the structure from time to time to ensure it is still right for the business and that the business has not outgrown it.

There are two basic forms of business organization available in Ontario:

(1)  Unincorporated business which may be:

Sole proprietorship – this is a business owned by one person. The owner has complete control over the business and receives all of the profits and incurs all of the debts. A Sole Proprietorship is the easiest and least expensive to organize but it has the highest exposure for personal liability (for example, the owner’s home may be exposed to creditors of the business);

Partnership – also an unincorporated business but the difference is there are two or more owners/partners. Each partner is jointly and severally liable for the debts of the partnership. It is crucial to know what each partner is doing and how he or she is committing the company. For this structure a Partnership Agreement is very important as it defines the management responsibilities, cash obligations, interests in the business, allocation of profits for each partner and how the partnership can be terminated. A Partnership is more complex to organize, but can limit some personal liability with a partnership agreement and the business owner is not doing it alone;

(2) The second form of business organization is a Corporation – a separate and distinct legal entity from those who own it. Ownership of a corporation is through the ownership of shares in its capital stock. As a separate legal entity, a corporation can enter into contracts in the name of the corporation, sue and be sued in the name of the corporation, carry on business, buy and sell property, and form associations with other corporations or individuals, and even own another corporation.Although a Corporation is the most complex organization, there is flexibility – it can be run by one person or with others. The biggest benefit of a corporation is that it has the lowest exposure for personal liability. The owners of a corporation are not generally liable for the debts and obligations of a corporation (for example, a shareholders’ house is not available to the corporation’s creditors).

In addition to the limited liability that a corporation affords, there are other benefits as well:

• Ownership of a corporation is transferred easily by transferring the shares.  It can be as simple as endorsing the back of the share certificate in favour of the new owner of the shares.  But selling shares can be much more complex given the type of business carried on, the value of the business and the requirements of the Buyer.
• Flexibility in setting up a corporation’s share structure can allow for a variety of different types of owners. Non-voting preference shares may be sold to a silent investor, non-voting participating shares may be given to employees in recognition of their contribution to the company and different classes of shares can be set-up for family members.
• Since a corporation is a separate legal entity from the shareholders, the corporation can have perpetual existence.  It continues as a corporation in law even if the ownership of the corporation itself changes.  This provides for continuity of the business.
• Tax Advantages:  If a corporation qualifies as a small business and has active income, then it may be able to take advantage of the small business deduction and pay income taxes at a substantially reduced rate.
  • A tax deferral is possible by retaining earnings in the corporation
  • Another important tax advantage is that the capital gains exemption for sale of a small business is only available on the sale of shares of a qualifying corporation and not for the sale of a sole proprietorship or a partnership
• For a number of reasons, it can be easier to raise capital for a corporation than it is for a partnership or sole proprietor.  Lenders are often more willing to lend capital to a corporation.  And there can be more sources of capital for a corporation.
• The use of a holding company is also available for corporations. Implementing the proper share rollovers and filing the required election can make the setting up of a holdco easy and tax effective.

What are the disadvantages of a Corporation?

And of course where there are advantages to something there are always disadvantages.  Some of the disadvantages of incorporating are:

• Corporations are governed by more statutes and have more reporting obligations. For example if a corporation does not file its annual return under the Corporation Information Act each year it may be cancelled.
• The cost of organizing and maintaining a corporation can be greater than for a sole proprietorship or a partnership.
• A corporation will be required to keep records of its shareholders, directors and officers, as well as records of its debts.  Records of various other transactions or changes in the corporation must also be kept.
• Corporations need to have resolutions when dividends are declared and need to maintain annual resolutions in the corporate records. Annual resolutions approve financial statements, appoint the accountant and confirm all of the actions taken by the directors in the previous year. Some corporations put their owners at risk because they are not meeting the legal requirements for operation.
• While the general rule is limited liability, there are situations where directors and even shareholders of a corporation could be held personally liable for certain acts or failures of the corporation.

Take these factors into consideration when choosing a business structure and be sure to obtain legal and accounting advice so that the structure best fits the business.