Should I Incorporate? Understanding Business Structures for Canadian Entrepreneurs
One of the most frequent questions I hear from entrepreneurs is, "Should I incorporate?" The answer to this question varies depending on individual circumstances, so let's dive into the different types of business structures and the pros and cons of each. This post will focus on for-profit organizations, but you can refer to our previous post about charities and not-for-profits for more information on those entities.
When deciding whether to incorporate, there are two key questions to ask yourself:
1. What are the liabilities/risks associated with the business I'm conducting, and do I want those liabilities/risks separated from me personally?
2. How much money is left in the business after I've taken out what I need to live? If you're taking out everything you're making, you won't see a tax advantage in incorporating.
Types of Business Structures in Canada
1. Sole Proprietorship
A sole proprietorship is the most straightforward and most often chosen by new business owners in Canada. One individual owns this type of business, as the name would suggest, and from a legal standpoint, the business is an extension of you. The owner is entitled to all profits and is responsible for all business debts, losses, and liabilities. Remember that even though your business is an extension of you, having a separate business bank account is still necessary, to keep your business transactions separate from your personal transactions.
Advantages:
Easy and inexpensive to form.
Complete control over the business.
Simplified tax reporting, as income is reported on your personal tax return.
Disadvantages:
Unlimited personal liability for business obligations.
Difficulty in raising capital.
The business ceases to exist with the owner, complicating succession planning.
2. Partnership
A partnership involves two or more people agreeing to share in a business's profits or losses. Like a sole proprietorship, a partnership is easy to establish. There are two common types of partnerships in Canada: general and limited. Regardless of which partnership you choose, a partnership agreement needs to be created with the help of a lawyer. Like with all collaborative endeavours, people are people, and mistakes happen, and sometimes, things don’t go as you originally planned.
General Partnership:
All partners share in the management of the business and are personally liable for the business's debts.
Limited Partnership:
This partnership includes both general and limited partners. General partners manage the business and are personally liable for debts, while limited partners contribute capital and share profits but have limited liability.
Advantages:
It is easy to establish a partnership agreement.
Combined resources and expertise.
Shared responsibility and decision-making.
Disadvantages:
Joint and several liabilities for partners in a general partnership.
Potential for conflicts between partners.
Profit sharing can lead to disagreements.
3. Corporation
A corporation is a more complex business structure that offers liability protection to its owners. Because it is a separate entity, it can "sue and be sued." During incorporation, ownership is divided into shares between the shareholders/stockholders. There are two distinct types of corporations: private and public.
Private Corporation:
A private corporation is a business owned by a small group of shareholders that does not offer its shares to the public. These corporations are not listed on any stock exchange. Ownership is often reserved for family members, close friends, or a select group of investors. Private corporations are common among small—to medium-sized businesses.
Public Corporation:
A public corporation is a business entity that offers its shares to the public and is typically listed on a stock exchange. The shares are public, so anyone can buy and sell them. Public corporations are subject to regulatory requirements and must provide regular disclosures and reports to regulatory bodies and the public.
Advantages:
Limited liability for shareholders.
It is more straightforward to raise capital.
Perpetual existence, allowing for a more effortless transfer of ownership.
Disadvantages:
More expensive and time-consuming to establish.
Increased regulatory requirements and administrative complexity.
Separate tax return must be filed for the corporation.
Critical Considerations for Incorporating in Canada
When deciding whether to incorporate, you need to consider the following factors:
Liability and Risk
The nature of your business significantly influences the need for liability protection. Incorporating can shield your personal assets from business liabilities if you operate in a high-risk industry (e.g., construction, healthcare). In contrast, a low-risk business (e.g., consulting, freelance writing) may not require the same protection level.
Tax Implications
Incorporation can offer tax advantages, but it depends on how much money you retain after covering personal living expenses. Corporations can benefit from lower tax rates on retained earnings, allowing for reinvestment and growth. However, the tax benefits diminish if you're withdrawing all profits for personal use.
Investment and Growth Potential
Corporations have more favourable structures for raising capital. Incorporating can enhance your business's credibility and appeal if you plan to attract investors or secure significant financing. Sole proprietorships and partnerships may struggle to achieve the same level of investment due to perceived risk and lack of formal structure.
Administrative Requirements
Incorporation comes with increased administrative responsibilities, including regular reporting, record-keeping, and compliance with provincial and federal regulations. Since a corporation is a separate entity, it must have a separate tax return filed annually. Evaluate whether you have the resources and capacity to manage these requirements effectively.
Conclusion: By understanding the different business structures you can make the best choice for you whether or not to incorporate.
Deciding whether to incorporate is a critical decision that can significantly impact your business's success and sustainability. Incorporation offers valuable benefits, such as liability protection and potential tax advantages, but it also comes with increased administrative responsibilities and costs. Ultimately, the right decision depends on your unique situation and vision for your business's future.
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I LOVE banishing the “finance scaries” by teaching entrepreneurs in an easy-to-understand way. If you’re reading this, you might benefit from my FREE Financial Health Check, which will assess how you’re doing with the financial management of your business, and provide you with customized resources that will hopefully resonate with you.