There are three common types of legal structures for a business: sole proprietorship, partnership, and corporation. The advantages and disadvantages of each structure are explained below.
Sole Proprietorship
This structure is informal and easily created. The business and the operator are the same to legal and tax authorities. The business’s profits, debts and responsibilities are those of the operator. This structure offers some tax advantage as losses from the business can be deducted against other income of the operator (if any). However, the CRA will typically not allow an individual to deduct losses for too many years before denying them and insisting that the business is a hobby and not a business in pursuit of profit.
Sole proprietorships are usually used in the early stages of a business or for part-time businesses. This structure becomes tax-inefficient as the business grows and succeeds. Moreover, it offers no liability protection and the operator’s personal assets can be exposed to the debts and liabilities of the business.
Partnership
Similar to a sole proprietorship, except that two or more individuals or corporations are required to be carrying on business with a view to profit. The profits, losses and obligations of the partnership flow through to the partners. A partnership is not a distinct legal entity for tax purposes.
The provinces regulate partnerships, and each recognize general partnerships and limited partnerships.
- General Partnership
A general partnership may be formed with a written agreement. The debts and obligations of the partnership flow through to each partner on an unlimited basis.
- Limited Partnership
A limited partnership is comprised of at least one general partner and any number of limited partners. The general partner(s) manage the affairs of the partnership and are limited for debts of the partnership. The limited partners are liable for partnership debts/liabilities to the amount of their capital contribution to the partnership (ie, their liability is “limited”).
A limited partnership is distinct from “limited liability partnerships,” which are usually only available to professionals (such as lawyers and accountants). Limited liability partnerships offer partners more liability protection (as the name suggest) than if they were general partners. In limited liability partnerships, a partner is not exposed beyond their capital investment to the labilities of their partners.
Corporation
A corporation is a legal entity distinct from its shareholders. A corporation has the legal abilities of a natural person (ie, a corporation can lend and borrow money, sue and be sued, etc.).
Shareholders of the corporation are not responsible for the debts/liabilities of the corporation beyond their invested capital.
Corporations can be incorporated under provincial or federal law. The decision under which law to incorporate usually depends on which jurisdiction the company will operate in, name requirements, cost, etc. In some cases, companies that wish to carry on business which is subject to federal regulation, should be incorporated federally.
Corporations are usually comprised of three groups of individuals: shareholders, directors and officers. In small, closely-held corporations (few shareholders), the same individual or group of individuals may be the shareholders, directors and officers. The shareholders appoint the directors. The directors (who manage the business of the corporation) appoint the officers, who manage the day-to-day affairs of the corporation.
In Canada, there are tax advantages that may be available to Canadian controlled corporations, such as lower corporate tax rates and tax-free capital gains on disposition.