Hey Guys! Today’s post is gonna contrast incorporation versus business partnerships in Ontario.
I am a lawyer and have been doing this for more than ten years. I have had the privilege of working with entrepreneurs in a wide variety of industries. (It is actually one of the best parts of this job.)
Last year, when we first got locked down, I was of course a bit shocked. As time goes on, I started thinking about how I can give something back to our community. One idea was to create this blog as a source of credible, reliable information. In particular, I am hoping that this first set of blog posts are helpful for guys (and girls) who may be first-time entrepreneurs.
It’s all good, man. Let’s do this!
Incorporation Versus Business Partnership
There is a joke that lawyers love to say 'it depends.' While it's not especially funny (am I missing something?), it is true. The best vehicle for taking your business to the next level will depend on your circumstances and the facts of your business.
Incorporation is a powerful legal structure that works well for many entrepreneurs. It has both legal and business advantages. If your business can afford the associated costs (in terms of both time and money), then yes, by all means, go ahead and incorporate.
BUT, starting and maintaining a Canadian corporation may be outside of your budget when first starting up. Just because the corporation is a good option in many cases does not mean that it is the best option in all cases.Let's dive in a little deeper.
Suppose there is more than one owner of the business. In that case, the natural alternative to incorporation is going to be a business partnership.
What is a business partnership?
The word partnership gets used in various contexts within the law. For instance, of course, there is the notion of a domestic partnership. In fact, the world of business affairs is the original context for the law's use of the term partnership.
A business partnership can be understood simply as two or more people carrying on business in common with a view to profit. This means that ownership and, unless specified otherwise, management of the business is shared between two or more persons.
Section 2 of the Ontario Partnerships Act, puts the matter in more technical terms:
"Partnership is the relation that subsists between persons carrying on a business in common with a view to profit, but the relation between the members of a company or association that is incorporated by or under the authority of any special or general Act in force in Ontario or elsewhere, or registered as a corporation under any such Act, is not a partnership within the meaning of this Act."
In fact, three types of business partnerships are possible in Canada. They are a general partnership, a limited partnership, and a limited liability partnership.
The general partnership is the most common type. For that reason, today's post is only going to consider the general partnership.
In the following, I am going to compare three features of the corporation and a business partnership
- Limited Liability
- Flexibility
- Tax treatment
Ill also briefly address a bonus, fourth point of comparison.
As the big homie Freddy Mercury liked to say: “The Show Must Go On.” …. Let’s do this.
Feature 1: Limited Liability
At law, a corporation is a separate entity from its owners.
The corporation's separate legal identity results in limited liability for its owners. A corporate shareholder has limited liability because his financial liability is limited to whatever amount he has invested in the corporation's share capital. Put more simply, the most the shareholder can lose is whatever he (or she) has put into the corporation. Even if the corporation goes into debt and is ultimately unable to pay back its creditors, those creditors will not be able to go after the shareholder's personal assets.
In contrast, a business partnership does not enjoy legal personhood. It is therefore not separate, at law, from its owners. The result is unlimited liability, which is the most severe disadvantage of doing business as a partnership.
The owners of a business partnership are personally liable for the business' obligations. This means that if the partnership incurs debt, each owner will be personally liable to re-pay all of the debts. As a result, the business' creditors can and will go after the partners’ personal assets. (An exception is the Limited Partnership. We will discuss the Limited Partnership in another post, but it is generally not relevant to first-time entrepreneurs.)
This difference between limited liability and personal liability is the first point of comparison between a corporation and a business partnership.
Feature 2: Tax
A corporation is a separate and distinct legal person. As a result, a corporation must file its own annual corporate income tax return. The Canada Revenue Agency (“CRA”) refers to this as a T2.
To file a T2 with the CRA, a corporation’s accountant will need to prepare thoroughgoing financial statements. Also, there are administrative requirements directly related to the preparation of the T2, such as maintaining a corporate minute book in case the CRA decides that an inspection is needed. Therefore, a corporation is not going to provide its owner with tax simplicity.
But, the corporation does provide the opportunity for tax savings. The possibility of tax savings that can be achieved through incorporation will primarily take two forms:
small business deduction
lifetime capital gains exemption
The small business deduction will apply to the first $500,000 of corporate income each year. It results in effectively lowering the corporation’s tax rate to about 12.5% in Ontario. The lifetime capital gains exemption kicks when you sell shares of your business. In that case, you may be able to personally take slightly less than $900,000 out of the corporation tax free. (There are going to be eligibility criteria to understand about both of these programs.)
The key point is simply that these mechanisms for achieving tax savings are available to corporations.
In contrast, a business partnership is not a legally separate entity from its owner. This is going to result in greater tax simplicity but less scope for tax savings.
In short, the business partnership will not file its own tax return with the CRA. Instead, the partnership's profit will go directly to the partners as income. The partners, i.e., the business’ owners, will then include that income on their personal tax return with the CRA, i.e. on his T1. The income is then taxed, all other things being equal, at the higher rate for high-income individuals.
Therefore, tax-treatment is another significant difference between a corporation and a business partnership.
Feature 3: Flexibility
Incorporation creates a structure that is both flexible and potentially dynamic. Let’s look at a few ways in which this flexibility manifests.
As I’ve written elsewhere, the corporation has multiple actors with distinct responsibilities. Shareholders collectively own the business, but they do not directly make strategic business decisions. Instead, shareholders must elect at least one director - or a board of directors - who make these decisions and monitor their execution. In turn, the board appoints senior management, i.e., “officers”, who run the day-to-day business.
A major consequence of these differentiated roles is that a corporation can issue shares, even when the investors are strangers. The added layers of accountability built into a corporation make the corporation the preferred business structure of most investors. In turn, the prospect of diffusing ownership makes the corporation especially attractive for entrepreneurs who intend to raise equity financing.
The partnership, however, is a different story. A typical scenario is that each partner might bring a complementary skill set . For instance, one partner might focus on customer acquisition while the other handles the product’s technical details. Another common albeit more sophisticated permutation of the partnership is that one partner brings financial horse-power while other partners bring technical expertise -- this is the basic model of a hedge fund!
Whatever the division of roles in a partnership, it will result in an organization that is ‘flatter’ than a corporation. It is also historically thought to be more difficult for a partnership to raise external investment. Whether you go with a partnership or corporation will in part depend on whether you embrace a professional approach to management. Even if you stick with a partnership, it is recommended to plan ahead through a partnership agreement.
Feature 4 -- Bonus: Less Up Front Cost
So far, we have covered two features where the comparison is almost always favorable to the corporation and a third where the corporation usually comes out ahead. Let’s also consider a factor that, on balance, points towards the business partnership as a desirable structure for new businesses.
Simply put, there will be less up-front cost and less need for outside service providers if you choose to do business through a partnership.
In my experience, this San Francisco-based lawyer puts the matter very clearly:
It is noteworthy that while the advantage of the limited liability entities are clear both in terms of limited risk and tax planning, most businesses in the United States are either sole proprietorships or partnerships. The reasons for this are usually based on the way most businesses get started. Quite often family members simply combine in a business thus forming a defacto oral partnership and especially at the commencement of business, taxes are not critical (since little money is made) and limited liability not a major concern since there often are few assets owned by the original owners to protect. ….
Nevertheless, besides the up-front cost savings associated with a partnership, there are also convenience advantages associated with the partnership. In short, a partnership will be less regulated than a corporation.
Bottom Line
Overall, the winner is the corporation. Incorporation can be a powerful vehicle for taking your business to the next level. But, there are certain circumstances where a partnership might be most appropriate.
It really does depend on your personal circumstances and the facts of your business: the best vehicle for taking your business to the next level is going to depend on your own personal circumstances and the facts of your business.