This series of blog posts will cover commonly asked legal questions from entrepreneurs just starting out. Our goal is to help you make the distinction between what you can do by yourselves and where you should pull in a legal expert.
In this first article, Sammy breaks down everything you need to know about how to choose the right business structure. Take it away, Sammy!
How to Choose the Right Legal Structure for Your Business
To preface, some legal jargon is unavoidable. I’ll make sure to define any terms that might be unclear or complicated to make this as easy to digest as possible.
There are a few different types of legal entities that businesses can take on in Canada. Most commonly, the three to concern yourself with as a new business owner are sole proprietorship, partnership, and corporation.
- A sole proprietorship is a business owned and operated by one person.
- A partnership is a business owned and operated by two or more people.
- A corporation is a legal entity separate from its owners, with the ability to enter into contracts, sue or be sued, and own assets in its own name. A corporation is recognized as an individual with its own special rights and responsibilities in Canada.
One of the biggest differences that exist between these three business structures is your personal exposure to risk as you conduct your business. All these structures will be explored in more detail below.
What Is a Sole Proprietorship?
A sole proprietorship is an unincorporated business that is owned by one individual. In Canada, it is the simplest kind of business structure. The owner of a sole proprietorship has the sole responsibility and right for making decisions, receiving profits, and claiming losses, and under this structure, you do not have a separate legal status from the business.
This means that as a sole proprietor, you also assume all the risks of the business, which can and might even extend to your personal property and assets. From a tax perspective, your net business income will count toward your personal income tax. You can register a business name, operate under your own name, or both if you want to under this structure.
The most important aspect to understand about a sole proprietorship is that the owner retains full legal responsibility of the proprietorship’s dealings. This means that the assets of the owner may be seized to settle claims against the sole proprietorship. There are ways to limit this through contract or via insurance.
With that being said, the reason some people elect to use this structure is due to how simple and inexpensive it is. A sole proprietorship is created as soon as you start working on your own with no extra paperwork necessary. The benefits of going this route mean that only you are the owner of your business, and tracking revenue and expenses is made easier since there are no disclosure obligations or special accounting knowledge needed. Additionally, you have complete control over the decision-making process, and you can grow your business and scale in an organic way. The sole proprietorship is often used by entrepreneurs as a jumping board to partnerships and incorporation.
What Is a Business Partnership?
There are three kinds of partnerships to be aware of:
- General partnership
- Limited partnership
- Limited liability partnership
1. General Partnerships
A general partnership in Ontario is created when the partners (i.e., you and someone else) carry on a business with the common intention of generating a profit. The “intention” can be a verbal agreement, a written agreement, or it can be implied by action. Implied by action means that the behavior of the partners, along with the circumstances and the activities they carry out together, indicates they want to run a business to generate a profit. You can register a partnership under the Business Names Act, but you don’t need to.
Under this stricture, the partners will share both profits and losses, and they share all the rights and obligations both jointly and severally*.
It’s always good practice to have a partnership agreement that determines the rights and obligations of each partner, there is no legal requirement to have one but in the absence of an agreement, the Partnerships Act will govern the relationship.
2. Limited Partnerships
The limited partnership has the same goal as the general partnership but provides a bit more structure in the form of general partners and limited partners, who will assume different responsibilities respectively.
General partners will manage the daily operations of the partnership, typically they will receive a salary and or benefits. The limited partner is typically responsible for investing money or property to the partnership and in return, will receive a fraction of the profits as agreed upon in the partnership agreement.
A big difference under this structure is found in the liabilities assumed by the general and limited partners. The general partner will typically retain a personal liability for all dealings of the partnership, essentially identical to that of a partner in a general partnership. The limited partner is only liable up to the amount of capital they invested into the partnership.
A limited partnership must have a partnership agreement and is obligated to respect the rules set out in the Partnerships Act, The Limited Partnerships Act, The Business Name Act, and the Common Law*.
3. Limited Liability Partnerships (“LLP”)
This business structure operates in the same way as the limited partnership, but it is reserved for individuals who carry out a profession recognized by the law, like accounting firms and law firms. Three conditions must be met to establish an LLP:
- The Act that regulates the profession must expressly permit its members to carry out their professional activities under an LLP.
- The body that governs the professional order must require the maintenance of liability insurance.
- The LLP must register its name under the Business Names Act.
In terms of liability, under this structure, general partners are joint and severally liable except for acts or omissions that are deemed to be negligent. Additionally, limited partners are shielded from any liability arising from the business of the partnership.
What Is a Corporation?
A corporation is a separate legal entity in which the people forming it will own an interest in it (also known as shareholders). In Ontario, incorporating can be done either provincially or federally.
The reasons people incorporate are the following:
- It provides legal security and can completely shield the members from liability.
- It’s easier to secure financing, and it provides tax advantages.
The disadvantages of incorporating are:
- Depending on how shares are distributed, you might lose some control of your business,
- It’s the most expensive business structure, and
- It requires constant and regular maintenance in terms of filing taxes and yearly reviews with the government.
Which Legal Structure Should I Choose for My Business?
A big consideration when starting your business and choosing your preferred business structure is how much revenue you expect to generate at the start.
If you’re starting out small and solo, it might not be necessary to complicate your life with excessive costs in establishing a corporation from the outset, so a sole prop could be just right.
Next, take a chance to look at what liabilities you have. Can they be mitigated with a partnership agreement? This can be a cost-effective way to conduct business and manage your resources from the outset while you gain clarity and vision for your future venture. Working with a lawyer to formalize a partnership agreement can help make sure both you and your business partner are starting out on the right foot. Yes, even if you’re family or long-time friends (especially if you are). You’ll never regret setting clear expectations.
If you’re planning to have significant revenue, or have multiple partners, you may want to incorporate. It’s recommended to have a lawyer incorporate your business; however, at Juristii, we rarely recommend going this route from the outset. There are many tools to help entrepreneurs get started in the most cost-effective way possible.
If you have any more questions about how to choose the right legal structure for your business, you can reach out to me at juristii.com.
Stay tuned for the next article in the series, “How to Read a Contract Properly”. Is there another legal blog topic you’d like us to cover? Let us know in the comments.
- “Jointly and Severally” is a legal term indicating that responsibility is shared by two or more parties to a lawsuit. The injured party may sue any of them or all of them, and in the collection of damages, they can collect the total damages awarded by a court from any or all of them. in layman’s terms, this can be defined as: Liable as both an individual and a group together.
- “Common Law” is the term used to define the rules set out by the courts in their rulings of previous cases set before them.