Small Business & Start-ups: Part One: Structure
Updated: Feb 6, 2020
There are significant advantages to considering various business legal structures and choosing the right legal structure for your situation at the start of your business venture. Advantages can include, but are certainly not limited to:
Managing potential liability for debts, obligations and liabilities of the business undertaking and/or business stakeholders and facilitating asset protection through structures that avoid, or at least reduce, the potential personal liability of those involved in the business undertaking.
Managing tax payments and other tax related obligations of the business undertaking and/or business stakeholders and facilitating tax planning to potentially avoid, or at least potentially reduce, the amount of taxes required to be paid.
Managing founding and on-going third-party and cash-flow financing of the business undertaking and facilitating various types and methods of financing in consideration of the rights, restrictions and obligations associated with any particular type of financing.
Managing the relationships, obligations and legal rights of the business stakeholders, whether founders, investors, management, employees or contractors, and facilitating the removal of cash or assets from the business undertaking from time to time by business stakeholders.
Managing the desired time line of the proposed business undertaking and facilitating potential exits when and where appropriate by sale or business combination or, in certain circumstances, facilitating the ability to pass the business on to heirs.
The time, effort and nominal cost in considering business legal structures at the start of a business undertaking seldom outweigh these potential advantages. However, delaying the implementation of a proper business legal structure until “there is something of value” can itself mean exceptional time, effort and cost in dealing with tax issues and liabilities, the various interests (real or not) in the undertaking that may then be claimed and the assets and liabilities that have accrued either to the business or some or all of the business stakeholders.
For the typical small business or start-up, there are three basic forms of legal structure.
First, there is a sole proprietorship (when the business is owned and operated by one individual, without any other formality, and that individual is therefore responsible for the business and its liabilities). Start a business on your own without doing anything else and you likely are doing business as a sole proprietorship.
The sole proprietorship structure is extremely simple and, at least at the start, cheap with few legal formalities or complications. All benefits and liabilities of the business flow through to the individual – who is 100% responsible for its debts and liabilities – and all earnings are taxed as the individual’s personal income. While simple and cheap (certain licensing and provincial name registration requirements may still apply) one potential short coming of the sole proprietorship structure is that, unlike a corporation, assets of the sole proprietorship (being, in fact, the assets of the individual) are at risk in order to satisfy any and all liabilities of the business. This structure also suffers from a lack of options for financing, business succession and opportunities for tax planning.
General and Limited Partnerships
Second, there is a partnership (when two or more individuals or corporations carry on business together with a view to profit). Start a business with one or more other persons without doing anything else and you likely are doing business as a partnership.
The above may not be entirely what was intended and problems can arise as between “partners” since among other things: (a) each partner can liable for the debts and obligations of the partnership on an unlimited basis; (b) the profits and losses of the partnership flow through, on a proportionate basis, to the partners who must pay tax on these amounts personally; and (c) certain duties are deemed to arise as between partners of a fiduciary nature that can in many circumstances place burdens or restrictions on partners that were not discussed nor intended.
The various provinces in Canada have exclusive jurisdiction with respect to partnerships, and accordingly, each province has enacted specific partnership legislation governing either or both a basic general partnership or a somewhat more complicated limited partnership (an arrangement composed of at least one general partner, who manages the affairs of the partnership and is liable to an unlimited extent to creditors of the partnership, and any number of limited partners who must not participate in the management of the partnership but, in turn, have liability to creditors of the partnership limited to the amount of capital contributed).
It is prudent, at the very least, for potential business partners to understand the provisions of the applicable provincial legislation. However, it is highly recommended that advice be obtained generally and that a proper partnership agreement be drafted to better set out the participation, rights, restrictions and obligations of the partners involved.
Finally, there is the corporation or company (a separate legal entity given, by virtue of the formality of its creation and administration, almost the same status as a natural person in that it can own property, carry on business, borrow, lend, sue or be sued) by far the most common business structure in Canada. A corporation or company can only be established through a formal legal process and each province (as well as the Canadian federal government) has enacted specific corporate legislation governing the establishment, administration and dissolution of corporations. Where you incorporate typically involves some consideration of the scope of your business, the various residency requirements for directors and the costs of incorporation and maintenance.
The company earns revenue, incurs losses and pays taxes (often at a lower rate than individuals) separately from its owners. Owners’ liability is, generally, limited to their investment in a corporation (ie. the owners or shareholders are not personally responsible for the corporations liabilities - although some exceptions exist at law and in certain circumstances this limitation is circumvented by the use of personal guarantees requested from third parties (like landlords and lenders). A corporation has an existence separate and apart from those of its owners and management and continues to exist as directors, officers, employees and shareholders come and go. Financial institutions and investors tend to be more familiar with, and therefore generally more comfortable with, providing capital and loans to a corporation and share structures can be set up to facilitate outside investment and provide options as to when and how shareholders or investors take money out of the company.
Although the corporation is perhaps the most common business entity, consideration of the pros and cons of each structure is a worthwhile undertaking in consultation with an accountant, lawyer and other business stakeholders. It is also important that business owners understand the duties and administrative requirements associated with each, and start their enterprise with both the correct structure and an understanding of that structure, in order that any anticipated benefit is not lost or any avoidable liability is not brought upon the business or the business stakeholders.
Does not constitute legal or other advice and must not be used as a substitute for legal advice from a qualified legal professional in your jurisdiction who has been fully informed of your specific circumstances. Information may not be up-dated subsequent to its initial publication and may therefore be out of date at the time it is read or viewed. Always consult a qualified legal professional in your jurisdiction.