Options for Canadian Business Structures

If you are starting a new business you should be aware that there are numerous business structures available, and the most appropriate one will depend on your specific industry, situation, and objectives. Below is an overview of common business structures in Canada, excluding trusts, which are not commonly used for active businesses in Canada but are used in overall tax planning.

Sole Proprietors

Sole proprietors conduct business personally, reporting the business income on their personal tax returns. To deduct business expenses the taxpayer must have been doing business during the timeframe when the expenses were incurred. The Canada Revenue Agency considers that a business has begun once significant activity related to earning income starts, or other normal business operations commence.

Advantages:

1. Minimal startup costs – all that’s required is a separate bank account and business number.
2. Ability to deduct business losses against personal income for tax purposes, reducing your tax burden.
3. No costs for withdrawing business funds, as there is limited separation between business and personal finances.  While it is important to collect all business revenues in your business accounts and to pay your business expenses from those accounts, at the end of the day, all you need to do is to transfer available profits to your personal account.  You are encouraged to pay personal expenses from your personal accounts and not from your business accounts.

Disadvantages:

1. Personal responsibility for all business debts and liabilities. This means that if the business fails and creditors are owed, the taxpayer’s personal assets could be taken.
2. If the business is profitable, the taxpayer may pay a much higher tax than if the business was structured as a corporation. The highest federal personal tax rate for 2023 is 33% vs. the highest federal corporate rate of 15% (provincial/territorial taxes also need to be= factored in).
3. The business ceases to exist upon the taxpayer’s death.

Partnership

A partnership is a business relationship between individuals engaged in a common profit-oriented enterprise. Determining partnership status may require adhering to relevant provincial laws.

Advantages:

1. Income earned in a partnership flows through to each of the partners, based on their partnership percentage.
2. Losses incurred by the partnership flow out to the partners, and can be claimed for immediate tax savings.
3. Limited liability partnerships offer liability protection to their partners, based on the amount they each contribute to the partnership.

Disadvantages:

1. If the partnership is a limited liability partnership, losses are restricted based on the at-risk rules.
2. If the partnership is a general partnership, there is no limited liability for each partner. Partners are all responsible for each other’s actions and liabilities.
3. If certain criteria are met, a partnership must annually file a T5013 – Partnership Information Return.
4. The partnership ceases to exist upon the death of its partners or when it is deliberately and legally dissolved.

Corporation

Incorporation of a business creates a legal entity which most governments (including Canada and the U.S.) empower with legal rights similar to many that citizens have. It also designates persons or officers with the responsibility for assuming certain legal duties and decision-making capabilities on behalf of the corporation. Canada, but is not always the most efficient, especially for U.S. persons living or operating in Canada.

Most corporations utilize the issuance of both shares and debt for capitalization, but all corporations must authorize and issue shares. The appropriate share capital structure will be dependent on the shareholder’s income tax and other non-business objectives. The legal presumption is that all shares are equal with respect to votes, participation in assets, and profits of the corporation. That is why assigning shares specific rights and restrictions in the articles of incorporation is an important step to achieve the taxpayer’s objectives for the corporation. The amount that the shareholder invests in the share capital of the corporation can generally be returned to the shareholder tax-free, which is why the concept of paid-up capital is so important for tax purposes.

Among the many advantages of incorporation are these:

1. Since a corporation is a separate legal entity, there is limited liability for the shareholders. They are not personally liable for the debt of the corporation and can only lose what they invest in the corporation. However, the Canadian Business Corporations Act (CBCA) places a number of obligations on corporate directors, who can be held liable for certain acts or failures to act.
2. A corporation will continue to exist even if every shareholder and director dies. Its shares would simply be transferred to the shareholders’ estate or heirs.
3. A corporation has a greater ability to obtain financing and capital than an individual does. Corporations can issue shares or bonds and can often borrow money at lower rates, since financial institutions typically view loans to corporations as less risky than loans to individuals.
4. A corporation has lower tax rates than any of the other business structures, especially if it is eligible for the small business deduction. This allows the corporation to defer taxes by leaving the income it earns within the corporation, where it’s taxed at lower tax rates than it would be if were transferred to an individual or individuals – who are usually taxed at higher rates.
5. Corporations qualify for numerous tax incentives that other business structures are not eligible for, such as:
   1. Small Business Deduction: The federal tax rate is 9% on active business income earned within a Canadian-controlled private corporation making $500,000. By contrast, the personal federal tax rate (as of 2023) increases to 33% after $235,675 of taxable income − and provincial/territorial rates must also be factored in.
   2. Income splitting: A corporation allows income splitting between family members, subject to Tax on Split Income (TOSI) and “kiddie tax” rules. This is typically done by having the family members invest and become shareholders of the corporation, and by paying them dividends − or salaries if they legitimately work in the business.
   3. Investment tax credits: A corporation can qualify for various investment tax credits such as those for scientific research and experimental development.
   4. Capital Gains Exemption: If the shares of a corporation qualify, each shareholder is entitled to a $971,190 (2023) deduction on capital gains on the sale of the corporation’s shares. See our blog on the Capital Gains Exemption for more details.

Some disadvantages of incorporation are:

1. There is double taxation when a shareholder withdraws funds from the corporation. The profits are taxed at the corporate level and then subject to personal income tax at the shareholder level when a dividend is paid.
2. The start-up costs for a corporation are higher compared to any other business structure. A lawyer needs to create articles of incorporation, register the corporation, and authorize and issue shares. There will likely be continuing legal and accounting fees.
3. When a corporation first begins operations, it may generate losses for a significant period of time. These losses are trapped within the corporation until the business starts generating income, at which point the losses may be used to offset taxes on corporate profits.

Although this article focused on some of the most common business structures in Canada, as a cross-border wealth management firm we recognize that some of these structures may have limitations from a cross-border perspective. Each person and each business has unique needs and circumstances.  To review your own specific cross-border entity planning considerations, please contact Cardinal Point and take advantage of our depth of knowledge and experience in these areas.