Choosing a Business Entity: A Brief Overview for Small Businesses in Ontario
When you start a business, you have to pick the kind of business entity you will conduct business through. Often, however, a person with a good idea will start their business without really spending much time on making this first choice. This usually isn’t the best strategy — at least not in the long run. This post provides an overview of the main types of business entities available to small businesses and their respective advantages and disadvantages.
Choosing a Business Entity
A business entity is an organization created by an individual (or multiple individuals, in some cases) to conduct business, engage in a trade, or otherwise pursue profit.
There are different types of business entities but the main ones are:
Sole Proprietorship: an unincorporated business that is owned by one individual
Partnership: a relationship between two or more people who are carrying on a business in common with a view to profit
Corporation: a legal entity that is separate and distinct from its owners
Factors Differentiating Types of Business Entities
Each type of business entity mentioned above has its advantages and disadvantages. The choice of business entity is not about what is right so much as it is about what is right for your business and your objectives. When determining which type of business organization is best suited for a particular business, there are a number of considerations that generally come into play including:
Complexity and cost of start-up
Exposure to liability
Relationship between ownership and management of the business
Tax consequences
Continuity of the business
Ability to raise capital
Scale of the business
Advantages and Disadvantages of the Various Business Entities
Sole Proprietorship
Sole proprietorships are the simplest kind of business structures and tend to be used most often with businesses that are small and localized. With a sole proprietorship, there is no distinction between you and the business — you are the business and the business is you. This is why income made from this type of business is reported directly on your personal annual income taxes. Sole proprietorships arise automatically when a person starts carrying on a business — there are few start-up costs or formalities as a result. However, the simplicity of this type of business entity can be a double-edged sword.
Advantages:
Low start-up costs and formalities
Owner retains all profits directly
Disadvantages:
Owner has unlimited personal liability for all the debts and obligations of the business (i.e., the personal assets of the owner are potentially at risk)
No real way to structure the business to improve tax efficiency
Can be difficult to raise capital — only method is to borrow money
Restricts growth (though there is no technical restriction on the number of employees, the fact that a sole proprietorship exposes the owner to unlimited liability does restrict growth)
Partnership
There are multiple types of partnerships, but the most common one is “general partnership” and that is the focus of this section. Recall the definition of partnership set out above — the focus is on the existence of a relationship between two or more people rather than any explicit agreement to the effect that a partnership exists. General partnerships, like sole proprietorships, arise automatically when such a relationship comes into being.
Advantages:
Low start-up costs and formalities (similar to sole proprietorships)
There is some flexibility to the internal managerial structure of the business (you can use a partnership agreement to structure the relationship between the partners)
Disadvantages:
Each partner has unlimited liability, jointly and severally, for all the debts and liabilities of the business*
Partners are seen to be agents of each other and of the business — that means the actions of each partner bind the other partners!
No real method to structure the business for tax efficiency
*This point merits further explanation. Essentially, if there are two partners, one of whom has a lot of personal assets and the other has no personal assets, the creditors of the business can go after one partner (the wealthy one) for the entire debt.
Corporation
Corporations are the most powerful and dominant form of business entity. There is a lot to talk about when it comes to corporations, but this post will be limited to some of the key features and characteristics of corporations.
Corporations are entirely creations of the law — what we sometimes refer to as a “legal fiction.” They are, essentially, artificial persons. Because of this, a corporation has many of the same rights and can do many of the same things as any real person (with some limitations), including: entering into contracts, earning income, holding assets, etc. Obviously a corporation, being, in fact, not an actual person, cannot act on its own behalf. Which is why corporations are structured so that there is a division of ownership and control. The ownership is in the hands of those who hold shares of the corporation, and the management is handled by a Board of Directors who are to act in the best interests of the corporation. In a small business, such as one with only a single owner, usually there is only one person who owns all the shares of the corporation and also acts as its sole director (i.e., controls the management of the corporation).
Advantages:
Limited liability of owners (=shareholders) — because the corporation is its own person and technically the corporation is the one who owns the business, generally the personal assets of the owners are not at risk
Business structure allows for separation of ownership and management (an advantage especially if the business is growing)
Enhanced ability to raise money (can borrow but can also sell shares as ownership stakes in exchange for money)
Perpetual existence (the corporation doesn’t die with the owner — it can be sold, passed to heirs, etc.)
Opportunity for tax efficiency (a topic that deserves its own post)
Corporations pay tax at a fixed rate lower than the personal income tax rates
Flexibility on methods of paying yourself out of the corporation (see: Salary or Dividend)
Disadvantages:
Complexity and cost of start-up (cost varies greatly depending on the needs of the business, but is generally not a significant obstacle for many small businesses)
Some formalities and ongoing requirements (ex. annual filings, separate tax returns, record-keeping)
What Next?
Whether you have an existing business or are about to embark on a new venture, it is a good idea to get some insight on what your options are. The type of business entity you choose has a significant effect on the future of your business (as well as your personal future). The above post offers only a glimpse into the world of business law and is not tailored to the unique circumstances of your business or your goals and objectives. If you need specific advice, or think you would benefit from a consultation, please contact us directly to schedule a meeting.
The above provides information of a general nature only and does not constitute legal advice. All transactions and circumstances vary and specific legal advice is usually required to meet your particular needs. Please consult with a lawyer if you have a legal question.
