Incorporation vs. Sole Proprietorships & General Partnerships: How Do They Differ in Canada and What’s Best for a Small Business Owner?
Entrepreneurs have several options for structuring their companies when starting a business in Canada.
This article explores the three main business structures Canadian entrepreneurs have to choose from:
Sole proprietorships
General partnerships
Corporations
When Should Small Businesses Incorporate in Canada?
Businesses should consider incorporating when::
Their liabilities become large enough that they present a serious risk to the business owner - in particular, before they hire employees and contractors or enter into significant contracts (such as a lease, or providing services to a major client);
Their tax obligations become large enough that they aren’t paying out the entirety of business profits as personal income;
The business is growing significantly;
The business owner is ready to take a serious run at expanding their business;
If they plan to sell their business in the future and want to take advantage of the Lifetime Capital Gains Exemption.
While the specifics of each business might differ, here are some general signs and considerations that suggest it might be time to incorporate:
Increasing Liability Concerns: If your business is in a sector where there's a higher risk of litigation or financial claims (e.g., construction, manufacturing, consulting), incorporating can protect your personal assets from business liabilities.
Revenue Growth: As your business income grows, the potential tax benefits of incorporation can become more attractive. Incorporated businesses benefit from a lower corporate tax rate compared to the personal tax rate on high incomes.
Seeking Investors or Loans: If you plan to raise capital, investors often prefer, or even require, that a business be incorporated before they invest. Moreover, some banks and financial institutions might find it easier to lend to a corporation than to sole proprietors or partnerships.
Planning for Permanence: If you want your business to continue after you retire or pass away, incorporating ensures that the business entity remains separate from your personal life and can continue indefinitely.
Expanding Internationally: If you're considering expanding your operations outside of your home country, incorporating can sometimes make this process smoother and more structured.
Obtaining Government Grants: Many government grants require that your business be incorporated and have employees before becoming eligible to receive funding.
Anticipating Sale or Business Transfer: Corporations can offer a clearer structure when it comes to selling the business or transferring ownership, given the delineation of shares.
Personal Financial Planning: Sometimes, business owners incorporate to better manage their personal financial planning, retirement planning, or estate planning. This could be to reduce on-going tax liabilities or to qualify for Lifetime Capital Gains Exemption in the event of a sale.
To try and help you understand when it may be appropriate to incorporate I’ve listed a few examples. Please note these are meant to be educational and you should consult with a lawyer first.
1. You run a copywriting business.
You have a few contractors that work for you, after personal taxes you net $70,000/year and your cost of living is $60,000/year.
In this scenario you have minimal liabilities, except your obligations under the contractor agreements,and you need the majority of the income to live on. You likely want to start with a sole proprietorship until you grow your business.
2. You own a bakery.
You have several employees. You net $90,000 and your cost of living is $80,000/year.
In this scenario an incorporation would be wise. You’re selling a product that consumers ingest, injuries may occur at your workplace, you have employees, and you likely have relatively large account payables. An incorporation can help shield you from these liabilities.
3. You own a septic company and your gross income is $400,000 per year.
You have employees. Your cost of living is $125,000 per year.
In this scenario an incorporation can be beneficial as it relates to a future sale, liabilities and a tax perspective. If you earn $400,000 on personal level you would owe roughly $170,000 in taxes in BC* which is an average tax rate of 42.15%. If your cost of living is $125,000 per year you need roughly $200,000 in pre tax income (in BC).
Leaving the other $200,000 in the business it would be taxed at an 11% rate assuming you qualify as a CCPC. This amounts to considerable savings.
*This is a very rough calculation.
The Pros & Cons of Different Business Structures in Canada
The Pros of Incorporating Your Business
Limited Liability: One of the most significant advantages of incorporating a business is that it provides limited liability protection to its shareholders or owners. This means that the shareholders’ personal assets are generally protected from the company’s debts and liabilities. If the business faces financial difficulties or legal troubles, the shareholders are not typically personally responsible for the company’s obligations beyond their investment in the business. Note that company directors are personally liable for unpaid employee wages and most tax obligations.
Separate Legal Entity: When a business is incorporated, it becomes a separate legal entity. This separation means that the corporation can enter into contracts, own property, and engage in legal activities in its own name. It also allows for perpetual existence, meaning the business can continue to exist even if shareholders change or pass away.
Tax Benefits: While corporations are subject to corporate income tax, they may also enjoy certain tax benefits. In particular, there are tax advantages for small businesses.
Transferability (Sale) of Ownership: The ownership of a corporation is typically divided into shares, which can be bought and sold relatively easily. This allows for the transfer of ownership interests without disrupting the business’s operations. It also allows you to access the Lifetime Capital Gains Exemption.
Access to Capital: Corporations often find raising capital easier than other business structures. They can issue stocks or shares, which can be sold to investors to raise funds for expansion or operations. This access to capital can be crucial for businesses with ambitious growth plans.
Credibility and Perceived Stability: Incorporating a business can enhance its credibility and perceived stability in the eyes of customers, suppliers, and potential partners. Establishing business relationships and securing contracts as a corporation is often easier via a corporation.
The Cons Incorporating Your Business
Complexity and Cost: The process of incorporating a business can be complex and costly. It involves filing articles of incorporation, adhering to regulatory requirements, and potentially hiring legal and accounting professionals to ensure compliance. There are also ongoing reporting and compliance obligations that can be burdensome.
Complicated Taxes: Once you incorporate you immediately have two taxes to file. Your personal taxes and your corporate taxes. Typically corporate taxes are more expensive to file. Even basic corporate taxes typically cost $1,500 + to file..
Formality and Regulation: Corporations are subject to formalities and regulations that may not apply to other business structures, such as sole proprietorships or partnerships.
Loss of Control: When a business is incorporated, the ownership structure may involve multiple shareholders or owners. This can lead to a loss of control for the founders or majority shareholders, as decisions may require the approval of the board of directors or other shareholders. If your business has more than one shareholder, you may need to enter into a shareholders’ agreement to get clarity on what happens in the event of the death or disability of a shareholder, or if a disagreement arises between multiple shareholders.
Reporting and Disclosure: Corporations are often required to disclose financial information and other details about their operations to government authorities and the public. This level of transparency may not be desirable for all businesses, as it can reveal sensitive information.
The Pros & Cons of a Sole Proprietorship in Canada
The Pros of Registering a Sole Proprietorship Business
Simplicity: Setting up and operating a sole proprietorship is straightforward and cost-effective. There is minimal paperwork and regulatory compliance, making it an attractive option for small businesses and startups.
Control: As the sole owner, you have full control over all aspects of the business, from decision-making to operations. You can make quick decisions without needing to consult with partners or shareholders.
Direct Taxation: In Canada, income from a sole proprietorship is reported on the owner’s personal tax return. This means that business profits are taxed at the individual’s personal tax rate, potentially resulting in lower overall taxes, especially if the business has losses that can offset other income.
Flexibility: Sole proprietors have the flexibility to adapt their business strategies and operations to changing circumstances without the need for extensive agreements or negotiations.
The Cons of Having a Sole Proprietorship Business
Unlimited Liability: One of the most significant disadvantages of a sole proprietorship is that the owner has unlimited personal liability for the business’s debts and obligations. Personal assets, such as the owner’s home and savings, are at risk if the business faces financial difficulties or legal issues.
Business Income is Taxed Personally: Personal marginal tax rates are substantially higher than corporate tax rates. An average tax rate of 42.5% would apply to $400,000 of earnings in a sole proprietorship. That same level of earnings in a corporate structure would attract a tax rate of 11%.
Limited Access to Capital: Sole proprietors may face challenges when it comes to raising capital. Banks and investors may be hesitant to lend money or invest in businesses with sole proprietors due to the higher risk associated with unlimited liability.
Limited Expertise and Resources: Sole proprietors often have limited expertise and resources compared to larger businesses or corporations. This can impact their ability to compete in the market and take advantage of growth opportunities.
Continuity Issues: The continuity of a sole proprietorship is tied to the owner’s life and health. If the owner becomes incapacitated or passes away, the business may face challenges in continuing its operations.
The Pros & Cons of a General Partnership in Canada
The Pros of a General Partnership Business
Ease of Formation: Similar to sole proprietorships, general partnerships are relatively easy to form in Canada. Partnerships can be established with minimal paperwork and formalities.
Shared Resources: Partnerships allow for the pooling of resources, skills, and expertise. This can help the business to secure financing, share responsibilities, and bring diverse talents to the table.
Pass-Through Taxation: Like sole proprietorships, general partnerships in Canada typically enjoy pass-through taxation. Business profits and losses are reported on the partners’ individual tax returns, potentially resulting in lower overall taxes.
Shared Decision-Making: Partnerships benefit from shared decision-making, with partners contributing to the business’s strategic direction and operational decisions.
The Cons of a General Partnership Business
Unlimited Liability: One of the most significant disadvantages of a general partnership is that partners have unlimited personal liability for the business’s debts and obligations. Each partner is individually and jointly responsible for the partnership’s liabilities. Limited Partnerships (LPs) can be established which do help limit the degree of exposure for each individual partnership, but there is a higher degree of complexity and legal drafting required than for an incorporation. In many instances, a corporate structure is more efficient.
Conflict Resolution: Disputes and conflicts among partners can arise, leading to challenges in decision-making and potentially damaging the business’s operations.
Shared Profits: Business profits must be shared among the partners based on the partnership agreement, which may not always align with each partner’s level of effort or contribution.
Limited Access to Capital: General partnerships may face limitations in raising capital, as potential investors and lenders may be concerned about the partnership’s unlimited liability structure.
Continuity Issues: General partnerships may face continuity challenges in the event of a partner’s withdrawal, retirement, or death. The partnership agreement should address these scenarios to avoid disruptions.
Key Differences Between Sole Proprietorships, Partnerships, and Incorporations in Canada
Now that we have defined the terms sole proprietorship, general partnership, and incorporation within the context of Canada, it’s time to take a closer look at how these three business structures differ.
Let’s examine seven key factors that differentiate these business structures from each other:
1. Formation Process
Sole Proprietorship: Forming a sole proprietorship is straightforward and involves minimal formalities. There are no registration requirements, making it the simplest form of business structure in Canada.
General Partnership: Establishing a general partnership is relatively easy and involves creating a partnership agreement outlining the partners’ roles, responsibilities, and profit-sharing arrangements. While not mandatory, registering the partnership is advisable. Note: a partnership can arise by virtue of two or more persons operating a business together, even without registration.
Incorporation: Establishing a corporation is more complex and involves filing articles of incorporation with the relevant government authority, such as Corporations Canada or a provincial agency. This process may also require additional documentation and compliance with corporate naming regulations.
2. Ownership & Management
Sole Proprietorship: In a sole proprietorship, a single owner has full control over the business. The owner is solely responsible for all aspects of the business’s management.
General Partnership: A general partnership involves two or more partners who share ownership and management responsibilities as outlined in the partnership agreement. Partners typically have equal authority and are jointly responsible for the business.
Incorporation: Corporations have a more structured ownership and management system. They have shareholders, directors, and officers. In some provinces, there may be residency requirements for directors, and corporations often have stricter regulations for share ownership. In British Columbia there is no residency requirement for directors, however, if the company is not controlled by a majority of Canadian residents, then it may become ineligible for CCPC status and attract a much higher tax rate.
3. Taxation
Sole Proprietorship: In a sole proprietorship, business income is reported on the owner’s personal tax return. The owner is taxed at their individual tax rate, and any business losses can be used to offset other sources of income. If you’re in the province of BC your provincial tax rates will be between 5-20.5% depending on how much you earn. Your federal tax rate will be between 15-33% depending on your income. At the highest marginal tax rate, this can mean that your business would be taxed 53.5% on every dollar earned.
General Partnership: Similar to sole proprietorships, general partnerships also enjoy pass-through taxation. Business profits and losses are reported on the partners’ individual tax returns.
Incorporation: The company itself is subject to corporate income tax, and shareholders are also taxed on any dividends they receive. However, Canadian-controlled private corporations (CCPCs) may be eligible for certain tax advantages, such as the small business deduction. Eligible small businesses in BC pay 11% on the first $500,000 of taxable income. Above $500,000, a rate of 27% applies in BC.
4. Reporting & Compliance
Sole Proprietorship: Sole proprietors have fewer reporting and compliance requirements compared to partnerships and corporations. They are not typically required to hold annual meetings or maintain detailed corporate records.
General Partnership: Partnerships have relatively simple reporting requirements, including the filing of partnership tax returns. There are fewer overall formalities compared to corporations.
Incorporation: Corporations must adhere to more stringent reporting and compliance requirements under the Business Corporations Act of British Columbia or the Canada Business Corporations Act. This includes holding annual meetings, filing annual reports, keeping minutes of meetings, and maintaining a proper corporate record book. Failure to do so can lead to penalties and legal complications.
5. Name & Branding
Sole Proprietorship: Sole proprietors have the flexibility to choose a business name but are often required to register the business name if it differs from the owner’s legal name.
General Partnership: Partnerships typically use the surnames of the partners or a combination of their names for the business. Registration may be required depending on the jurisdiction.
Incorporation: Corporations must follow specific naming regulations, including the use of terms like “Corporation," “Inc.,” or “Ltd.” in their names. The approval of the proposed name by the government authority is required. A trademark will be required to rigorously protect your brand.
6. Transfer of Ownership
Sole Proprietorship: Transferring ownership in a sole proprietorship is relatively simple and typically involves selling the business assets or operations to another individual or entity.
General Partnership: The partnership agreement can govern the transfer of partnership interests. Depending on the agreement, it may require consent from other partners or specific procedures.
Incorporation: The transfer of shares in a corporation may involve more regulatory hurdles, and approval from the board of directors or other shareholders may be required. This can make the process more complex and time-consuming. However, you may be eligible for the Life Time Capital Gains Exemption which allows you to sell the shares of your business and avoid capital gains of up to $971,190.
7. Termination of the Business
Sole Proprietorship: The continuity of a sole proprietorship is tied to the owner’s life and health. In the event of the owner’s death or decision to close the business, the sole proprietorship typically ceases to exist.
General Partnership: General partnerships may dissolve when partners withdraw or in accordance with the partnership agreement. Partnerships often have a limited life.
Incorporation: Corporations often have perpetual existence, meaning they can continue to exist indefinitely, regardless of changes in ownership or management. They can be dissolved voluntarily or through government action.
What is an LLC & is it Available in Canada?
A Limited Liability Company (LLC) is a business structure combining elements of a partnership and a corporation. This is a common business structure seen in regions like the United States, United Kingdom, Japan, and India — however, it is not currently an option for Canadian business owners.
Instead, Canadians have the option to choose between two types of business structures similar to LLCs:
Sole Proprietorship: A sole proprietorship is a business owned and operated by one person. All income and losses are reported on the business owner’s individual tax return, and the sole proprietorship does not grant the business its own tax status. According to the Government of Canada, a sole proprietorship owner has “sole responsibility for making decisions, receives all the profits, claims all losses, and does not have separate legal status from the business.” Sole proprietors also assume all business risks, which extend to their personal property and assets.
Partnership: A partnership in Canada is an association between two entities — be they individuals, corporations, trusts, or other partnerships — joining together to operate one business. Partnerships are easy to form and are governed by a written agreement. This agreement should detail what each partner is expected to contribute to the business in terms of money, labor, property, and skills, as well as the share of profits or losses each partner is entitled to.
Both sole proprietorship and partnerships are easy to obtain in Canada and come with a variety of benefits. However, unlike an LLC, owners of sole proprietorships and partnerships must deal with the bulk of business liabilities.
One way around this challenge is through a limited partnership — also called a Limited Liability Partnership or LLP for short — a type of partnership in which a single general partner has majority ownership of the company and is responsible for making important business decisions.
What is an Incorporation & How to Set One Up
An incorporation is a distinct legal entity that is separate from its owners and governed by federal and provincial laws. To create an incorporation, a business owner must complete the following steps as outlined by the Department of Innovation, Science, and Economic Development in Canada:
Name Your Corporation: To become an incorporated business, business owners must select a name for the company. This name is how the corporation is legally identified and can be either a word name made up of letters and symbols or a numbered name made up of letters and numbers. Numbered names are considered the simplest way to name an incorporation, as government officials provide the number to the business owner.
Create Your Articles of Incorporation: Articles of incorporation are a set of documents filed with the Canadian government that legally document the creation of the corporation. When creating and filing your articles of incorporation, you can choose between a basic incorporation which includes a predetermined set of articles of incorporation, or a custom incorporation that requires you to customize the articles to your specific business needs. Articles of incorporation must be written in either English or French. Your lawyer will typically draft your articles, and they are customizable for your unique situation depending on the plans of your business, whether or not you are transferring property into the corporation, how many shareholders you have and what plans for financing you have.
Establish a Registered Office Address & Board of Directors: To be an incorporated business in Canada, you must have a registered office address and a board of directors (or a single director). The registered office address must be where corporate records and official documents are stored, as well as where official documents can be served to your business. Typically the law firm you work with will serve as your registered and records office. As for your board of directors, the candidates you choose to serve on your board must meet the province of incorporation’s or Canada’s Director requirements.
Submit & Pay a Fee: Once you have completed all of the above steps, you must submit all necessary documentation to the Government of Canada and pay the fee to incorporate your business. The simplest means for submitting your incorporation application and paying the relevant fees is to visit the Online Filing Center.
How to Choose Between a Sole Proprietorship, Partnership, or Incorporation in Canada
Ultimately, the choice between incorporation, sole proprietorship, or general partnership in Canada should align with your specific business goals, risk tolerance, and the nature of your business.
Unless you are a large business or expect strong growth over the next few years, a sole proprietorship or general partnership is likely your best option.
Sole proprietorships offer simplicity and direct taxation but come with unlimited personal liability. Meanwhile, general partnerships provide shared resources and decision-making but also involve unlimited liability and potential conflicts among partners.
Consulting with legal and financial professionals can help you make an informed decision that suits your needs and minimizes risks. Each structure has its own trade-offs, and what’s “better” depends on your specific priorities and circumstances.
Additional Resources:
Visit the Government of Canada’s Small Business and Self-Employed Income webpage for more information on sole proprietorships and general partnerships. If you are looking for more resources on becoming incorporated, check out the official webpage for Business Corporations.
