The Best Business Structure for your Client
Determining the best business structure is often a collaborative process among the client, the client’s accountant and you. Remind your client of the accountant’s important role when you are consulted for advice. If you can, develop an arrangement with your own accountant so you can call him or her with your own questions to confirm the accuracy of any advice that you give.
The most common choices for a small business are:
1. Sole Proprietorship
This structure arises as a matter of law when the client commences carrying on business in his or her personal capacity and generally requires very little legal work. However, operating as a proprietor exposes the client and his or her personal assets to all of the risks and liabilities of the business.
A sole proprietorship may be perfect for a client who is not looking to limit liability to customers and who wants relative simplicity with respect to taxes, not the least of which is eliminating the cost of having to have two income tax returns prepared, as would be the case with a company. Remember that a company is a separate legal entity that will have to file its own income tax return and this can be a costly process.
There are generally two aspects to the issue of limiting liability: The first is the client’s wish to reduce or eliminate the possibility of being liable for the unpaid debts of the business. However, since lenders, landlords and suppliers often insist upon personal guarantees from small business owners, a business structure created to limit liability may offer little practical protection from the most significant liabilities the business is likely to face.
The second aspect is the client’s wish to eliminate the possibility of being liable for injury or damage to others or their property. This aspect may be able to be addressed through insurance and the client should be encouraged to discuss the prospective business with a competent insurance broker, particularly if the business will have employees, an office that is open to the public, or one or more vehicles which will be used for business purposes, etc.
A sole proprietorship can be a good way to start when a business’ profitability is uncertain, because the individual proprietor is able to deduct reasonable start-up losses from other income. (Remember that a corporation is a separate legal entity. Losses incurred by the company may never be deductible if, for example, the company never has any income.)
The client will be obligated under the Partnership Act to register the name of his or her proprietorship with the Corporate Registry in Victoria if the business involves trading, manufacturing, or mining, and if the name is other than his or her own name, or if the name is his or her own name with the addition of "and Company" or some other word or phrase indicating a plurality of members in the business. However, even if the business does not involve trading, manufacturing or mining, registration of the proprietorship can be useful for other purposes such as evidencing the commencement date of use of the client’s trade name for trademark purposes.
2. General Partnership
A general partnership involves the operation of the business by two or more partners who are willing to pool assets and liabilities in common. This structure will also occur as a matter of law and it can also work well for low risk ventures. Generally speaking, all of the partners in a general partnership are jointly and severally liable for the debts and obligations of the partnership, and Section 7 of the Partnership Act provides that acts of every partner who does anything in the usual course of the business of the partnership bind the firm and his or her partners – in other words, an act or omission of partner A can create liability for partners B and C.
The provisions of the Partnership Act apply to all persons carrying on business in common with a view to profit, unless they have agreed otherwise or are precluded from being partners by reason of Section 3 or Section 4 of the Act. Section 21 of the Partnership Act allows such persons to vary the rights, duties and liabilities imposed by the Act, and you should familiarize yourself with these provisions if you are advising clients on a partnership.
Although the Partnership Act does create basic rights and remedies for partners, it is generally based upon a presumption that all partners will share equally in the revenues and expenses and in many, if not most, partnerships this will not be the case. In those situations a formal partnership agreement will be required to determine the partners’ rights, interests and obligations and deal with issues such as admission and expulsion of partners, etc. There is a useful checklist for drafting partnership agreements in “General Partnerships”, Working With Partnerships 2009 (The Continuing Legal Education Society of BC).
A general partnership is not usually treated as a separate legal entity for income tax purposes. The general partnership must be registered in accordance with s. 81 of thePartnership Act.
3. Limited Partnership
A limited partnership is available only where permitted by the Partnership Act. It involves the operation, management, and control of a business venture by a general partner (who bears unlimited liability for the risks of operation) and the investment by “passive” limited partners, whose liability is limited to the amount of their contribution to the partnership through the acquisition of units or other capital investments in the partnership. Part 3 of the Partnership Act provides for the formation of a limited partnership.
Section 64 of the Partnership Act provides that a limited partner is not liable as a general partner unless he or she takes part in the active management of the business. What this provision means in practice is that a limited partnership structure will be of limited usefulness in situations where all the partners intend to have an active role in the operation of the partnership.
Further information on limited partnerships is available in “Working with Limited Partnerships”, Working With Partnerships 2009 (The Continuing Legal Education Society of BC).
4. Limited Liability Partnership
A relatively new structure available in British Columbia is the limited liability partnership, or LLP. An LLP is particularly useful for professional partnerships because of its unique feature of insulating each partner from liability for the negligence of the other partners.
Under Part 6 of the Partnership Act a general partnership or limited partnership can become an LLP by registering as such under the Act. Once properly registered, an LLP offers each partner protection from liability for the acts or omissions of another partner beyond each partner’s interest in the partnership. In other words, if a particular partner commits an act or omission, the assets of the partnership remain at risk for any consequential liability, as do the personal assets of the partner who committed the act or omission. However, the personal assets of the “innocent” partners are not exposed to liability unless the “innocent” partners were involved or acquiesced in the act or omission of the “guilty” partner.
The provisions of the Partnership Act, which remove the limited liability of limited partners if they are involved in the management and operation of the partnership, do not apply to the LLP. All partners are therefore free to participate in the operation of the LLP and involvement or acquiescence in the act or omission giving rise to liability is the only relevant factor affecting a partner’s limitation of liability.
The partners of an LLP get the same income tax treatment as the partners of a general partnership.
Further information on LLPs is available in “Understanding and Working with Limited Liability Partnerships”, Working With Partnerships 2009 (The Continuing Legal Education Society of BC).
By far the most common structure that legal practitioners will recommend for use in British Columbia is a company incorporated under the Business Corporations Act (BCA). Less frequently, a federal corporation formed under the Canada Business Corporations Act will be used where the client anticipates operating in multiple provinces or federal incorporation provides other advantages (e.g., as to the naming of the corporation). In most cases the company will have a limited number of shareholders (often referred to as a “closely held company”). Companies with significant numbers of shareholders or those that intend to offer their securities to the public are beyond the scope of this module.
A corporation is considered to be a separate legal entity from its shareholders and, thus, where a company is formed to operate and manage a business, it will be the company which bears the liability for the business, not the investor/shareholders (except to the extent that they owe money or property for the issue price of their shares).
There are several advantages to a corporate structure:
- Immortality – a company continues to exist without interruption even if all its shareholders change and even if, for a period of time, it has no shareholders.
- Limited liability – a corporate structure limits shareholder personal liability for most debts, claims and obligations of the company. There are several important exceptions, most notably for a number of statutory claims, such as income taxes, where the directors and officers of the company (who are often, if not always, shareholders) will have personal liability for company obligations. Lenders, major suppliers, and landlords often insist on personal guarantees from company principals, which will eliminate the limited liability advantage of a corporation to the extent of the guarantee. However, insulation from customer claims, trade debts and many other third party claims will still be available.
- Transferability of shares – transferring proprietorship or partnership interests can be cumbersome but the mechanics of transferring a shareholder’s interest in a company are straightforward.
- Raising capital – can sometimes be more easily accomplished by selling shares than trying to raise partnership contributions, given the liability protection available to shareholders.
- Tax treatment – the tax treatment of companies is constantly changing and an accountant should be consulted on the structure and tax rates. Some corporations receive preferential income tax treatment according to the nature of their business or the residence of their controlling shareholder(s), but there can also be less desirable tax treatment for business losses. The Law Society’s Professional Legal Training Course practice materials provide a good summary of tax issues relating to corporations.
- Timing and control over personal income recognition – a corporate structure allows a degree of control over the amount and timing of income recognition in the hands of shareholders (i.e., control over when dividends or management fee payments are declared and the amounts to be declared, etc.) and may permit income-splitting among shareholders that is not otherwise available in a partnership or proprietorship structure.
- Rights of shareholders – the laws protecting shareholder rights are well developed.
- Speed of formation – once a corporate name has been approved by the corporate registry, the company can be formed instantaneously by electronic filing.
For more information about the principal income tax implications of earning income through proprietorship, partnership or incorporation, please refer to “Impact of Tax Issues on Business Structures”, Private Companies: Structuring the Entrepreneur(2005, The Continuing Legal Education Society of BC) as well as “Basics of Corporate Taxation and Distributions”, Tax Driven Transactions (2010, The Continuing Legal Education Society of BC). Tax issues are always evolving and appropriate accounting and tax advice is always a must.