Selecting Your Business Structure – Sole Proprietorships, Corporations, Partnerships – Which is Right for You? – Part I
When you decide to start your own business, you need to determine what type of business structure best suits your needs. Business structures range from sole proprietorship, corporation, partnership, limited liability partnership or joint venture.
Of these, the most common forms of business arrangements are the sole proprietorship and corporation. We will begin our discussion with a closer look at the sole proprietorship. In part II, we will look at the corporation, and in part III, we will examine the partnership structure.
A sole proprietorship is the most basic form of business organization and can be used in a wide variety of circumstances.
A sole proprietor occurs when one person, acting alone, pursues a business endeavour with a view for profit. A sole proprietor is not a corporation, but must be assigned a Business Number (BN) from the CRA. A sole proprietor files his or her business taxes together with his or her own T1 tax return by completing an additional scheduled called a form T2125.
Sole proprietorships are relatively inexpensive to set up and require few legal formalities. A sole proprietorship exists whenever an individual carries on business for his or her own account without the involvement of other individuals, except as employees.
No Limited Liability
A major disadvantage of sole proprietorships is that there is no limited liability for the sole proprietor; all business and personal assets may be seized in satisfaction of the sole proprietor’s liabilities. That is, all obligations including losses and liability associated with the business are the sole proprietor’s personal responsibility and his or her personal assets are at risk.
If you choose to operate as a sole proprietorship under a name other than your own, you will require a Master Business Licence (MBL). For example, if your name is Adam Smith and you wish to do business in Ontario under the name ‘Adam Smith,’ you are not required to obtain a Master Business Licence. However, if you wish to operate as ‘Adam Smith’s Plumbing’ or ‘Adam’s Advanced Landscaping’ or simply ‘Advanced Plumbing Solutions,’ you are required to obtain a Master Business Licence pursuant to s.2(2) of the Business Names Act in order to operate your business. The MBL certifies your trade-name and gives you the ability to operate a business under this name.
A great tax planning reason to operate as a sole proprietor occurs when your business expects operational losses in its initial year(s) of business, while you continue to earn a salary from your current employment. In this circumstance, your business losses can be shifted against your other income, thereby producing a return of your source tax deductions. If you were to incorporate, you would separate these losses and lose this valuable tax saving tool.
Another tax advantage is that the use of an accountant is not necessarily required. A sole proprietorship and the person running the business are one entity. Therefore, the sole proprietorship need only file one simple personal income tax return (T1). By contrast, a corporation must file a separate complicated return (T2 Return).
A major tax disadvantage of running a business as a sole proprietor is that your entire business income is subject to personal income tax rates. In Ontario, the average combined marginal personal income tax rate is 38%. This means you are paying 38% tax on your net business income. However, a corporation’s tax rate is only 26.5% for large corporations and as low as 12.2% (in Ontario, effective January 1, 2020) for most small business corporations. This means, by operating your business as a corporation as opposed to a sole proprietorship, you save as much as 25.8% in tax!
In other words, if you operate as a sole proprietorship, you take home about $62.00 for every $100 of income. As a corporation, you take home about $86.50 for every $100 of income. There’s a huge tax saving to operate as a corporation.
If your business earns more money than you need to presently live, you are paying more tax now and losing valuable investment earning income.
For example, Adam’s total personal expenses are $65,000 per year, plus an additional $10,000 for travel and entertainment. That means that Adam only needs $75,000 to live. If his business is earning $100,000 in business income, he is paying a high rate of tax (38%) on the additional $25,000 for no reason. If he wants to invest this extra income to grow his money, this leaves him with only $15,500 to invest after taxes ($25,000 x 38% tax rate).
However, if he operates through a corporation, he pays 38% on the $75,000 he needs to live (due to integration), and he pays only 12.2% tax on the remaining $25,000, which is $3,050. If he wants to invest this extra income to grow his money, this leaves him with $21,950.00 to invest after taxes ($25,000 – $3,050). This means each year Adam has about $6,450.00 more to invest to earn investment income. Multiply this by a reasonable rate of investment return, and that’s an extra $12,222.16 in additional income over 10 years just by using this tax planning tool.
Summary of Advantages of Sole Proprietorship:
• Easy and inexpensive to register
• Regulatory burden is generally light
• You have direct control of decision making
• Minimal working capital required for start-up
• Some tax advantages if your business is not doing well
• All profits go to you directly
Summary of Disadvantages of Sole Proprietorship:
• Unlimited personal liability. Your personal assets are at risk
• Income is taxable at your personal rate and, if your business is profitable, this could put you in a higher tax bracket
• Pay tax on all of the business income you earn at a high tax rate; lose investment income
• Lack of continuity for your business if you are unavailable; difficulty of transitioning business to next generation or selling business
• Can be difficult to raise capital on your own
For more information on the advantages and disadvantages of a corporation, continue reading to Part II – Selecting Your Business Structure – Sole Proprietorships, Corporations, Partnerships – Which is Right for You? or Contact Us to speak with one of our business lawyers.
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.