Which Entity is Best For Your Business

Ontario supports several options for the operation of a business. The three main options are sole proprietorships, partnerships and corporations.  In fact, there are six types of business entities because partnerships comprise three subcategories: general partnerships, limited partnerships and limited liability partnerships.  Similarly, corporations in Ontario have two primary subcategories: “regular” corporations and professional corporations.  Generally, sole proprietorships, partnerships and corporations  represent the common forms for business today. We will look at each of these types of business entities in just a moment.

There are other types of business entities which exist such as "S-Corporations" or "Limited Liability Companies". The latter two entities are mainly hybrids of two of the major types -- usually being a hybrid of a partnership and a corporation. However, for the moment, these types of business entities do not exist in Ontario or federally (although Nova Scotia and Alberta have created entities which somewhat resemble the American hybrid models). Thus, any time you are reading business journals, etc., especially those which are from the United States, care should be taken to ensure that references to LLCs are not confused with the corporation model of business entity. Also, one should note that while LLCs are not recognized or permitted in Ontario today, this does not preclude their introduction in Ontario tomorrow.

Joint ventures are also similar to partnerships but they can take the form of a corporation. A brief discussion about joint ventures is also set out below.

Sole Proprietorship

(a) Nature and Characteristics

A sole proprietorship is the most basic form of business entity which exists. For example, suppose Timmy goes out to the sidewalk with a table, a chair, some lemonade, paper cups, and a sign saying "Lemonade -- 5¢". Timmy clearly is in business and has set up a sole proprietorship.

Timmy is the sole owner of the business, even though he may have employees working with him (such as Lassie as security guard). For all legal intents and purposes, Timmy is the business and the business is Timmy. Put another way, Timmy will enjoy all the benefits of the business, such as profits from lemonade sales. However, Timmy is also personally responsible for all of the debts and obligations of the business. For example, if Timmy's business makes arrangements with Timmy's mother for the supply of water, lemons and sugar and sales are not enough to cover the expense of the supplies, Timmy's mother can sue Timmy personally for payment of the water, lemons and sugar.  Of course, in some instances Timmy can minimize the risk of being responsible for obligations through the purchase of business insurance.

There are few formal legal requirements to create or run a sole proprietorship. In some cases it can be quite as simple as Timmy setting up shop on the side of the street. However, some legal requirements may exist depending upon the type of business. Timmy the young child selling lemonade on the side of the street will not likely be bothered by legal regulations. However, Timmy the adult operating a hot dog cart in the downtown core on a sidewalk will likely need at least a municipal permit to carry on business at that location. Beyond compliance with municipal by-laws, certain types of businesses have attracted special legislation from the province to maintain standards, etc. Examples of such legislation include the Motor Vehicle Dealers Act, or the Real Estate and Business Brokers Act.

A common legal requirement is that imposed under the Business Names Act. This Act requires that no person may conduct business using a name other than his own unless he is registered under the Act. Thus, for example, if I set up my law practice and tell the world on my business card and correspondence that I am "Christopher A.L. Caruana, Lawyer", I do not have to register under the Business Names Act. However, if I say that I am "Caruana & Associates", then I will have to register under the Act. Registration is valid for five years, after which time you must renew the registration.

As already mentioned, Timmy is the business and the business is Timmy. The Canada Revenue Agency also sees sole proprietorships in this light. Therefore, if Timmy's lemonade stand makes $400 in a particular year, Timmy will have to report an income of $400. Timmy will also be able to claim the expenses from the lemonade business. Moreover, Timmy will be able to include the lemonade business as part of his overall income tax calculations. This can either be a benefit or a burden. For example, suppose Timmy made $10,000 mowing lawns last year and $40,000 from selling lemonade. If the lemonade income is included with the lawn mowing income, then Timmy had an income of $50,000 and this may bump him into a far higher tax bracket than if only the lawn mowing income was included. On the other hand, suppose that Timmy made $50,000 mowing lawns but lost money selling lemonade. In this case, the lemonade business losses can be offset against the lawn mowing profits and reduce the amount of tax paid by Timmy.

(a) Nature and Characteristics

A partnership arises where two or more persons carry on business together for profit. The key to realize is that the partnership is made up of two "persons" not two "people". The difference will be explained in more detail below, but the short explanation is that a corporation is a "person" in the eyes of the law. This means that a partnership can exist between an individual and a corporation.

The definition above requires that a partnership be an arrangement between two persons to carry on business together for profit. It does not automatically follow, however, that because two or more persons are acting in concert that they are acting as partners. For example, if Mr. Jenner's mother dies and leaves an apartment building to Mr. Jenner and his sister and they receive the rents from the building, they are co-owners of the apartment building, but not necessarily partners with respect to the business of owning and operating an apartment building. One requirement is that the persons are carrying on business together. This implies that they will be sharing the profits of the business in some manner. Another requirement is that they are carrying on business. Thus, several persons combining to buy property and set up a community centre or social club may not be seen as carrying on "business" and therefore not partners.
In general, it is safe to say that a partnership will exist where two or more persons carry on business together, have each contributed time, money, hard work, or other assets to the business, share in the profits and are both involved in the operation of the business.

(i) General Partnerships

A key feature of partnerships is that each partner is an agent of the other partner(s). If Mr. A and Mr. B decide to become partners in a business and Mr. A agrees with a supplier to purchase supplies or raw materials, Mr. B is obligated by the agreement between the partnership and the supplier. Only where it is clear that Mr. A is acting outside of the scope of the business (such as where Mr. A orders 73 sand blasting machines for a lemonade business), or where the third party knows that Mr. A has no authority to act for the partnership, will the partnership be able to avoid the obligations created by Mr. A's agreements.

As with sole proprietorships, partnerships are personal relationships between the business and the partner. Again, this means that if the partnership incurs debts which are greater than the assets of the business, creditors can look to the personal assets of each and every one of the partners. So, in the above example, the supplier can sue either or both of Mr. A and Mr. B for the price of unpaid supplies or raw materials delivered to the partnership. This applies for any manner of debts or liabilities owing by the partnership. So, for example, if Mr. B leaves a banana peel on the shop floor and Ms. P slips on it and hurts herself and sues the business and obtains a judgment against the business, Ms. P can seek payment from the business and, if it cannot pay, she can also seek payment from either Mr. A or Mr. B.

While the partnership is not a separate legal person from the partners themselves, the partnership is seen by the law as owning its own property. Assets of the business are considered indivisible while the partnership continues so that Mr. A cannot claim ownership of certain assets while Mr. B claims the remaining assets.  Rather, Messrs. A and B are entitled to share in the profits or losses of the business. This sharing can be set at a particular ratio (such as 60% for Mr. A and 40% for Mr. B), or if no ratio is set then the law assumes that the partners share equally. The same applies for the disposition of the assets of the partnership after it has been dissolved and the debts of the partnership have been paid.

A limited partnership is similar to a general partnership. Most of the rules which govern general partnerships also govern limited partnerships. The key difference between a general partnership and a limited partnership is that the latter has a limited partner or, usually, numerous limited partners and one general partner. A limited partner is best thought of as a "silent partner". In other words, someone who injects money into the business but does not take any role in running the business.

A limited partnership is comprised of at least one general partner and at least one limited partner. A general partner is the same as set out above: ie. he/she/it is responsible for the debts of the partnership if the partnership's assets are insufficient to pay the debts. On the other hand, a limited partner simply invests in the business and if the business owes more than it can pay, the creditors cannot go after the personal assets of the limited partner.

Limited partners can share in the profits of the business, and may give advice to the business on occasion but that is the extent of their participation. If a limited partner takes an active role in running the business, then he/she/it is no longer a limited partner and will be deemed to be a general partner in which case his/her/its assets can be seized by creditors to pay debts of the partnership.

Another difference between general partnerships and limited partnerships is that, in some instances, the general partner must obtain the consent of the limited partner before an action is taken. Again, one should recall that in a general partnership, if Mr. A contracts with the supplier, then Mr. B is also obligated by the terms of the contract. In some cases, if Mr. A is the general partner, he must get Mr. B's consent before Mr. A can act in a way which legally binds the limited partnership. However, these instances are rare and usually involve crucial issues to the internal management of the limited partnership, such as admitting new people into the limited partnership. Using the example of Mr. A contracting with the supplier, Mr. B as limited partner cannot say that Mr. A needed to ask him before a valid contract existed. In this case, Mr. B can only say, "okay supplier, try to pay off the debt owed to you with the business' assets, but if the debt is not satisfied, you cannot look to me for any more money."

(iii) Limited Liability Partnerships

The limited liability partnership is a hybrid of the general partnership and the limited partnership.  Like a general partnership, all partners are permitted to play a role in the operation or management of the business.  Unlike a general partnership, partners may not be at risk for all debts or liabilities of the partnership.  This latter principle is similar to that found for limited partnerships.  However, in a limited partnership, the limited partners’ risk for business debts, losses or liabilities is capped by the amount of the limited partners’ individual investments in the partnership.  In a limited liability partnership, this principle also exists – but it is restricted to claims for negligent acts or omissions.

Using again our example of Mr. A and Mr. B, if they set up a limited liability partnership, Mr. B will not be responsible for any negligent acts or omissions by Mr. A which Mr. A committed in the course of partnership business.  Mr. B is only responsible for his personal negligence or the negligence of any person (usually an employee) acting under his direct supervision or control.
The protection from liability, however, will only apply for claims of negligence.  Other claims such as breach of contract, are still governed by the rules applicable to general partnerships.  Thus, if Mr. A contracts with the supplier for raw materials and the business fails to pay, Mr. B will face personal liability to pay the supplier regardless of whether the business is operating as a general partnership or a limited liability partnership.

A limited liability partnership will be useful for professional partnerships such as lawyers, doctors, accountants and engineers where it is possible that one partner may not even be aware of work performed by his or her partners and whether that performance is proper or negligent.

General partnerships and limited liability partnerships are created by a partnership agreement and the name of the partnership must be registered in accordance with the Business Names Act. Limited partnerships, on the other hand, are legally created by filing a declaration with the Registrar of Partnerships. This declaration must be signed by both the general and all limited partners and must state among other things the partnership name, address, nature of its business, and set out which partners are general partners and which partners are limited partners. A new declaration must be filed either upon a change occurring in the composition of the limited partnership (ie. someone joining or leaving the limited partnership) or after five years of filing the previous declaration.

Partnerships are not considered to be a separate entity from its partners for taxation purposes. Partnership income (or losses) are determined and then the result is allocated among the partners in accordance with the partnership agreement (or failing such a provision in the agreement, on an equal basis).  Income or losses are said to “flow through” to the partners with the resulting disadvantage (like with the sole proprietorship) that money cannot be retained in the business and distributed to the owners on a “rainy day” or when tax rates would be lower.  In addition, partners are considered by the Canada Revenue Agency to be self-employed individuals for tax purposes.

(a) Nature and Characteristics

Corporations are the most commonly used entity through which one operates a business. A corporation is considered by the law to be a separate person with the full rights and abilities to act as natural human beings. Thus, if Timmy creates “TimCo Lemonade Limited" the law treats Timmy as one person and TimCo as another person. Unlike Timmy, however, TimCo can have perpetual existence. For example, Alexander Graham Bell died a long time ago, but his telephone company still does business on a grand scale. The notion that a corporation is an independent legal person is taken even to the point that a corporation can sue, and can be sued, in its own name.

Despite being recognized as a separate “person” at law, a corporation is a collectivity in that it cannot truly act on its own - it requires human beings to carry out its actions. Thus, a corporation will have a governing council (known as the Board of Directors) which handles major policy and administrative decisions. The day-to-day administrative matters and management are handled by the Officers of the corporation. In most cases, corporate officers will include a President and a Secretary. It is not uncommon to find the same person holding both positions. The owners of the corporation are the Shareholders who elect the Directors. The Directors in most instances appoint the Officers.

Even though a corporation must act through its human agents, the corporation can hold property, possess rights and incur debts or other liabilities separate from the shareholders. The main principle underlying a corporation is the concept of “limited liability". Suppose that Timmy and his brother Billy decide to incorporate TimCo and are the two shareholders of TimCo, each paying $10 and receiving one share. The capital of TimCo is $20 in cash. If TimCo then enters into an agreement with a supplier for sugar, water and lemons and the cost is $30 and the company does not pay, the supplier may only go after the $20 cash that TimCo has in its bank account. The supplier cannot go beyond the corporation and seek payment from either Timmy or Billy. Thus, Timmy and Billy s liability is limited to the amount that they invested in the corporation. It is this concept of limited liability which separates the corporation from other forms of business entities. Unlike the limited partnership (where at least one partner – the general partner – faces unlimited liability), all investors in corporations (ie. the shareholders) have limited liability.

If you recall, mention was made near the beginning of the possibility of confusion with the American Limited Liability Company and corporations. An LLC is more like a limited partnership in which no person has to be a general partner. It is not a separate entity, especially for taxation purposes, from the owners. On the other hand, a corporation is a separate entity from its shareholders.

In spite of the foregoing, the concept of limited liability may not be a reality. For example, it is quite common for banks and other financial institutions to require personal guarantees from shareholders especially when there are only a few shareholders and the corporation does not have a vast amount of assets. By giving the guarantee, in effect the shareholder has become answerable for the obligations of the corporation.

(b) Professional Corporations

Prior to 2001, only a handful of professionals (such as engineers) were permitted to incorporate their practices.  In 2001 the majority of professions were given this similar right – but it came with restrictions.  There are two major restrictions.  The first restriction is that a “shareholder” in a professional corporation does not have limited liability like a shareholder in a “regular” corporation – at least for professional liability.  Thus, if a law firm becomes a professional corporation, the shareholders will be protected from claims by their landlord for the failure to pay the rent for the offices, but they will not be protected from claims for negligence in providing legal advice.  The second restriction is that the shareholders of a professional corporation are restricted to members of the applicable profession.  Thus, for example, a professional corporation established by several accountants is restricted to having only the accountants as shareholders.  One of the large advantages of corporations is the possibility for what is known as an “income split”.  Suppose Timmy makes $50,000 in salary from TimCo.  If Timmy is married with two children, he may be able to make his wife and children shareholders of TimCo and pay the same $50,000 to himself and his family with the result that the tax paid by the four family members will be less than the tax Timmy would have to pay if he received the full $50,000.  (It should be mentioned, of course, that the Canada Revenue Agency does not like income splitting and uses what are called “attribution rules” to negate such attempts.  However, with careful tax planning by one’s accountant, even a minor income split may produce significant results.)  Under the current rules for professional corporations, if Timmy was a social worker, he would not be able to effect an income split with his family unless they were all social workers.  However, an important exception to this rule came into place in 2005 which permitted physicians and surgeons and dentists to have family members (ie. spouse and children) as shareholders of professional corporations – so there is hope that this will someday be extended to all other professional corporations. At the moment, the primary persons who would consider professional corporations are:  accountants, audiologists, chiropodists, chiropractors, dental hygenists, dental surgeons, dental technologists, denturists, dieticians, lawyers, massage therapists, medical laboratory technologists, medical radiation technologists, midwives, nurses, occupational therapists, opticians, optometrists, pharmacists, physicians and surgeons, physiotherapists, psychologists, respiratory therapists, social workers, social service workers, speech language pathologists, and veterinarians.

(c) Legal Requirements

The legal requirements for corporations leads one to an initial jurisdictional determination. In Canada, corporations can exist at either a provincial or a federal level. Provincially incorporated corporations are governed in Ontario by the Business Corporations Act (“OBCA"). Federally incorporated corporations are governed in Canada by the Canada Business Corporations Act (“CBCA"). The difference between the two is, not surprisingly, the geographical area within which a corporation can act. A CBCA corporation may conduct business anywhere in Canada. An OBCA may only conduct business within Ontario. If Timmy decides to incorporate TimCo in Ontario and then decides that TimCo should conduct business in Alberta, then TimCo will have to apply for registration as an extra-provincially licensed corporation in Alberta.

A further moment should be taken to determine what is meant by “conducting business in Ontario". The Ontario Extra-Provincial Corporations Act specifies that one is conducting business in Ontario if one: (a) has a resident salesperson or office in Ontario; (b) owns property in Ontario; or (c) otherwise carries on its business in Ontario. Unfortunately, the last instance is rather circular. However, the Act goes on to say that merely taking orders for, or buying, or selling goods or merchandise or offering or selling services through traveling salespeople or through advertising or the mail is not conducting business in Ontario. Other provincial legislation is similar in wording to the Ontario Act. Thus, if TimCo simply advertises in Alberta and sets up a 1-800 telephone number, but does not establish a TimCo satellite office in Alberta, then TimCo will not have to be registered in Alberta (assuming that the Alberta legislation is the same as for Ontario).

So, why then would it matter whether one incorporates provincially or federally? Several reasons may determine the choice of one over the other.

• will the corporation conduct business on a national level or locally? If nationally, will it operate out of more than one central location? If not, will it have a resident agent outside of its incorporating province?
• will the corporation sell products or services internationally? If yes, then there may be more of a psychological benefit for foreigners to know that they are dealing with a federal corporation rather than a provincial corporation.
• in some cases minor differences between the OBCA and the CBCA may provide a benefit to going for one versus the other. For example, federal corporations can hold Board of Directors meetings at any place in the world. On the other hand, unless the documents that created the corporation provide otherwise, Ontario corporations must hold such meetings somewhere within Canada. In some cases, this difference may actually matter.

Now that one has determined where to incorporate, what are the legal requirements? The only basic requirements are that the corporation have articles of incorporation (which must be filed with the appropriate government department), by-laws, and annually hold at least one shareholders meeting and one directors meeting. Both federal and Ontario corporations must prepared and submit annual filings to the government.

The articles of incorporation are best thought of as the Constitution of the corporation and will specify what classes, if more than one, of shares will exist. A shareholder has whatever rights are given to a particular share. In some cases the shares have the right to vote at shareholders meetings and in other cases the shares may not have a right to vote. Also, some shares may have a right to receive dividends (either of cash or other shares or securities of the company) while other classes of shares will not receive dividends.

Taxation is perhaps one of the largest issues for corporations. Unlike sole proprietorships and partnerships, the corporation is a completely separate legal person from the owners, and thus is treated as a completely separate taxpayer. Using our Timmy example again, if he makes $10,000 from mowing lawns in a year and TimCo makes $50,000 from selling lemonade, Timmy's income is only $10,000 since TimCo is a separate taxpayer and has to file a separate tax return.

Timmy and TimCo are also assessed income tax at different rates. An individual could have a marginal tax rate of as high as 46% whereas corporations have marginal tax rates only as high as 36%.  Moreover, if the corporation falls within the definition of a “Canadian-controlled private corporation”, the tax rate on the first $300,000 of business income is approximately half what would otherwise be payable.  As mentioned above, if an “income split” is possible, then additional tax savings can be obtained through the corporate structure.

Another difference is that tax losses do not flow through to shareholders, unlike the situation with partnerships or sole proprietorships. For example, suppose that Timmy makes $100,000 mowing lawns on his own but TimCo does poorly and loses $75,000. What Timmy would like to do is offset the $75,000 worth of losses against the lawn mowing profits and claim that his taxable income is $25,000 (being $100,000 profit less $75,000 losses). However, the losses are those of TimCo and not those of Timmy and so Timmy will have to pay income tax on the full $100,000.

Joint ventures are difficult to define with precision. In its broadest sense, a joint venture is any arrangement or association where two or more persons combine their resources in order to undertake a commercial venture. The association of two or more persons, as opposed to two or more individuals, means that corporations can be members of any joint venture. It is common to have corporations as parties to joint ventures and one need only think of the Hibernia Oil Project in Newfoundland which is a joint venture of several large oil companies.

Joint ventures are created through two methods: incorporation or agreement. An incorporated joint venture exists where the various parties agree to form a corporation to carry on the business venture and each party holds shares in the corporation. These corporations tend to have few shares issued and they are issued equally to ensure that no one party has more control over the joint venture than the other. Parties to the joint venture will also want to ensure equality among themselves by creating deadlocked boards of directors (with each party having the same number of directors and restrictions on voting majorities that require in effect the consent of all directors), by restricting share transfers or through unanimous shareholder agreements.

Unincorporated joint ventures are governed by their joint venture agreement. These agreements are usually quite lengthy because they have to establish the division of powers among the parties and how the joint venture will operate. As with the incorporated joint venture, the key concern will be to ensure that control is shared either equally or at least on terms with which all can agree.

Perhaps the most important consideration for anyone contemplating a joint venture is how it is to be concluded. If an emphasis is to ensure that all parties act in concert, problems immediately appear should a disagreement arise as to the direction of the joint venture. If these problems become serious, the joint venture will quickly fall into a state of paralysis since no one party can control the enterprise. Moreover, restrictions on share sales and the fact that few purchasers are willing to buy into a hostile and stalled business venture often result in the parties being truly deadlocked. To alleviate these problems, the parties will want to have either a unanimous shareholders' agreement or joint venture agreement which allows for mechanisms such as rights of first refusal, “shotgun buy-sell" provisions, “put" or “call" provisions or, if all else fails, the right for a party to apply to the court to dissolve the joint venture.

Taxation of joint ventures is strictly the result of the type of form taken by the joint venture. Thus, an incorporated joint venture will be subject to the normal tax rules for corporations. It becomes more tricky, however, with incorporated joint ventures. The Income Tax Act does not define a “joint venture". However, the Canada Revenue Agency has stated that the closer a joint venture resembles a partnership, the more likely it will be taxed as a partnership.

The answer to this question involves a balancing of the legal, practical and taxation aspects discussed above.  In making this determination, ask yourself the following questions, among others:

First, how important is limited liability to you. If the business suffers losses, is there insurance available? If not, do you have substantial assets (eg. a house) that you would wish to protect from the business creditors?  As well, practical considerations should be reviewed.  For example, under a limited liability partnership, the partners are liable for the losses of the partnership, but a partner is not liable for professional negligence by another partner unless the first partner was involved or had some supervisory role.  Contrast this situation with the same business operating as a professional corporation in which the shareholders have limited liability for “ordinary” losses of the business but are subject to full liability for professional negligence.  It is not hard to imagine a situation where the total “ordinary” losses of the business pale in comparison to the potential liability for a professional negligence claim.

Second, how many owners do you want for the business? If you want many owners or investors then the preference is for corporations or limited partnerships. If the number is low or only one, then sole proprietorships or general partnerships are preferred.

Third, how active do you want people in the business? If all investors want to have an active role in the operation of the business, then general partnerships or sole proprietorships are preferred. If you are seeking primarily investors, then the preference is for limited partnerships, limited liability partnerships or corporations.

Fourth, what is your anticipated taxation situation?  By working in conjunction with your accountant, your lawyer can assist you in determining which entity will be the most tax efficient method of carrying on your business.

An analysis of these often competing considerations as well as other considerations mentioned above will have to be made to determine which form of business entity is right for you.  If you have any questions or need help with the decision, please do not hesitate to contact our office.