There are many obstacles to be met by a prospective business owner prior to getting a start-up running. Incorporation or no incorporation?
For example, an entrepreneur must decide whether to operate as a corporation; and, if so, further determine what the optimum time is to incorporate the business in the start-up cycle. Incorporation is a key part to tax and liability planning.
For example, an entrepreneur must decide whether to operate as a corporation; and, if so, further determine what the optimum time is to incorporate the business in the start-up cycle. Incorporation is a key part to tax and liability planning.
In order to make that decision it is helpful to remember that there are three legal structures typically used in start-ups: sole proprietorships, partnerships and corporations.
Sole proprietorship
A sole proprietorship is a business structure owned and operated by a single person and is characterized by a lack of any legal distinction between the person and the business. In other words, the entrepreneur behind a sole proprietorship receives all the profits of the business but is also liable for all the business’s losses and debts. Your business income and expenses are included in your personal tax return and no separate return is filed for the business.
If you are expecting to incur losses in the start-up of your business there may be tax advantages in operating as a sole proprietorship, but only in the initial phases and only in situations where you will not incur significant liabilities such as leases and operating loans.
Partnership
A partnership is a business arrangement between one or more persons or entities who agree to work together for a common purpose with a view to making a profit. Frequently, a partnership or joint venture is formed between one or more businesses in which partners (owners) cooperate to achieve and share profits or losses. Individuals also enter into partnerships (sometimes inadvertently) to advance a new business.
In Alberta, the basic form of partnership is a general partnership, in which all partners manage the business and are personally liable for its debts. Remember, in certain circumstances, a partner can also be liable for the actions of a partner. Because of this fact, it is crucial for partners to have a partnership agreement.
There are two additional forms of partnership that are used, including the limited partnership (LP), in which certain limited partners relinquish their ability to manage the business in exchange for limited liability for the partnership’s debts, and the limited liability partnership (LLP), in which all partners have some degree of limited liability.
A corporation is a formal business structure with a separate legal personality from its owner or shareholders. It is the business structure most commonly utilized by entrepreneurs and small business owners.
A corporation is created by Articles of Incorporation in the jurisdiction of the business. The Articles of Incorporation and by-laws establish the framework for the business and set, among other things, the location of the registered office, the number of directors, the share structure and conditions attached to each class of share, the restrictions, if any, on the transfer of shares and the type of business that can be conducted by the corporation. The Articles of Incorporation can be quite complex, although for the start-up business it is best to keep things simple. Articles of Incorporation can always be amended.
There are many advantages to incorporating a business. The most commonly referenced advantage to incorporating a start-up is that, except in limited situations, a shareholder’s liability is limited to the amount invested in the corporation. In other words, unlike in the case of a sole proprietorship, an owner / shareholder is not personally liable for the obligations and debts of the corporation.
There are a number of other important benefits to incorporating, including the following:
· a corporation does not cease to exist when shareholders die or leave exit the business;
· a corporation is easier to sell when you are ready to exit the business;
· a corporation is able to sell shares in order to raise money;
· an owner of a closely held corporation can obtain tax advantages by controlling when personal income is received, whether by salary, bonus or dividend; and
· being incorporated provides the possibility of tax deferral when money can be left in the corporation and taxed at a lower corporate rate.
There are a number of disadvantages that should also be kept in mind, including:
· there are fees for the initial incorporation and the annual filing of required documents;
· separate tax returns must be filed for the corporation;
· the corporation’s losses cannot easily be passed on to shareholders; and
· lenders and landlords may still require personal guarantee’s thus undermining the benefits of limited liability.
Summary
There are advantages and disadvantages to each legal structure used in the start-up of a new business. For most business start-ups, incorporation will be the preferred approach to organizing your new business. We recommend that you discuss the options with trusted advisors such as your lawyer or accountant as early in the business formation as possible, and certainly before you start your new venture. Incorporation is often better done sooner than later. One of the mistakes new entrepreneurs most commonly make is waiting too long in the business start-up cycle to speak with their professional advisors.