Unfortunately there isn’t a simple answer to the question, “Should I set my business up as a sole proprietor, partnership, or corporation?” As with many accounting and income tax considerations, the answer depends on your unique situation.
Of course, if it’s just you in the business, then you won’t be able to use the partnership structure. Each of these three main ways to structure a Canadian business has their own advantages and disadvantages. Let’s take a quick look at all three.
A sole proprietor is the easiest form of business to set up. There’s really nothing you need to do unless you want to register your business name. In some provinces, you are required to register a business name if you won’t be operating under your own name. Check with your accountant to find out if this applies to you.
For tax purposes, your income as a proprietor is reported on your personal income tax return on either a Statement of Business Activities form or a Statement of Professional Activities form, depending on what type of business you have.
A partnership involves two or more people. We recommend you have a partnership agreement created by a lawyer which spells out each person’s role and how profits will be split. Your share of partnership income is reported on your personal tax return. If your partner is your spouse or other family member, you report business income from a partnership on a Statement of Business Activities form. This will be split in the proportion you have determined ahead of time.
If your partner is not your spouse or other family member, you may be required to file a separate partnership return. This can incur additional accounting fees. A partnership return is what’s called an information return. This means it’s required by the Canadian government and there are penalties for not filing it, but it doesn’t calculate tax owing. The tax is calculated once your share of the partnership income is transferred to your personal tax return.
Check with your accountant to find out if you are required to file a partnership return. They will determine this based on the specific details of your partnership.
One disadvantage of a partnership is you must determine the percentage of profit split ahead of time. If you decide that you and your spouse are going to split the profits of your business 50/50, you can’t change that ratio the following year to 25/75 because it saves you tax. If you want the flexibility of being able to allocate a different amount of profit to a family member from year to year, then you should discuss other options with your accountant.
A partnership can’t be an arbitrary agreement for the purposes of saving tax. Both partners must contribute to the business in some way, and the income split should reflect that.
A corporation is the most complicated business entity. It can also offer the most tax saving opportunities if your income has reached a certain level. It’s the corporate structure (who owns what type of shares) that allows for tax saving and planning opportunities. If you decide to go this route, it’s important to have a lawyer create and file the incorporation documents.
The reason a corporation offers some tax savings over a sole proprietor or a partnership is because corporations are taxed at a lower rate than individuals. You will only realize the tax savings of a corporation if you aren’t using all the money earned in the corporation. Any money you take out of a corporation is taxed on your personal tax return.
Where a corporation really starts to be a tax advantage is when you don’t need to take all the cash out of the company. Then business income is taxed at the lower corporate tax rate. Unless you know for sure you won’t need all the money earned in your corporation, there’s no reason to rush into incorporating your business. Some people prefer to do so for legal reasons. Check with your lawyer if you think this may apply to you.
Which is best?
At the risk of sounding like a broken record . . . The type of entity that’s best for your business depends on a lot of things. Not only are there tax considerations, but there are legal issues to think about too.
If you’re not sure the best way to go for your new business, we can help. Fill out this form to request your complimentary consult.