Business Structures
While the focus is often tax consequences, there is much more to consider when mulling whether or not to incorporate your active business. Protection from potential creditor claims may be a priority as well as set-up and ongoing costs and complexity. Generally business structures can be classified as Sole Proprietorships, Partnerships (including general, limited liability and limited partnerships) and Corporations. For our purposes, we will focus solely on (private) Small Business Corporations (SBCs) and their related benefits as below:
Sole Proprietorships
Owned by an individual, sole proprietorships must carry on active business and have a reasonable expectation of profit. As you might expect, an owner is personally responsible for all business debts and liabilities. Net business income is taxable in the year it is earned in the hands of the sole proprietor (at the owner’s marginal tax rate) regardless of whether the owner leaves money in the business or not.
Advantages:
- Easy to set up and dissolve
- Business losses are deductible against other income
Disadvantages:
- Unlimited liability
- Limited opportunities for tax deferral, avoidance, or conversion
- A sole proprietorship dies with the business owner
General Partnerships
Two or more owners (partners) carrying out a business activities together form a General Partnership. From a liability standpoint all partners are personally, though not necessarily eqially responsible for business debts and liabilities. Partners are allocated their share of business profits and losses according to their respective percentage ownership. As in the case of a sole proprietorship, profits and losses are included on each partner's (owner's) personal tax return; whether or not any cash or distributions have been paid in the course of the tax year.
Advantages:
- Easily arranged with a minimal amount legal manouvering and related cost
- Business losses by each partner are deductible against other sources of income
Disadvantages:
- Each partner is potentially personally liable for all partnership debts – creditors can obtain a judgement against the partnership and demand full payment from any one or all of the partners
Private Corporations
A corporation is a separate legal entity and as such enjoys its own rights and duties and may continue in existence beyond the passing of an owner or owners (shareholders.) Not a public corporation and not controlled directly or indirectly by any public corporation, qualified Canadian Controlled Private Corporations (CCPCs) may benefit from favorable tax treatment.
Advantages:
- Limited liability for shareholders
- Ability to raise capital (share issuance)
- Continuous existence
- Separate management and ownership functions
- Robust estate and succession planning opportunities
- Income retained within the corporation is only subject to corporate tax which is more often lower than an owner's (shareholder's) personal Marginal Tax Rate (MTR)
- Qualified Canadian Controlled Private Corporations may be eligible to claim a Small Business Deduction (SBD) on the first $500,000 (2009 and beyond) of active business income; effectively reducing federal income tax payable
- A $750,000 lifetime Capital Gains Exemption exists for qualified Canadian Small Business Corporations (SBC) shares, qualified farm property and qualified fishing property (certain rules and restrictions apply)
- A Small Business Deduction may be claimed on the first $500,000 (2010) of eligible income; reducing the effective corporate tax rate
- Capital Dividend Account (CDA) – a notional account which tracks the tax free portion of capital gains and other non-taxable incomes including death benefits received from company owned life insurance policies and the tax-free portion of goodwill; which may be paid out to shareholders as a capital dividend.
Disadvantages:
- Administrative costs (cost of incorporation, record keeping and annual filing costs)
- Investment income earned within a corporation may in fact be taxed at a tax rate slightly higher than the highest personal Marginal Tax Rate (MTR)
- Losses incurred by the corporation may be carried forward or back by the corporation only -- they cannot be claimed personally by owner-shareholders
