Please find some frequently asked questions below, with material to guide and explain various tax inquires.
A sole proprietorship is one person operating a business, without forming a corporation. The income of the business is then taxed in the hands of the owner (the proprietor), at personal income tax rates. The income is considered income from self-employment, and is included on the personal income tax return of the owner.
Advantages of proprietorship:
Setting up a business in the form of a proprietorship is relatively simple and the costs are low.
If the business loses money, the losses can be written off against other income of the proprietor.
Proprietorships are less regulated than corporations. The administration of a proprietorship is less costly than that of a corporation. However, proprietorships are regulated by the provincial/territorial governments, and the proprietorship may have to be registered.
The proprietor is in control of all decision making, and receives all profits of the business.
Disadvantages of a proprietorship:
The biggest disadvantage of a proprietorship is unlimited liability. The proprietor is liable for all debts and other liabilities of the business. If the business is sued, all the business and personal assets of the owner are at risk.
If the business is profitable, it will usually be paying higher taxes than if it was incorporated as a Canadian Controlled Private Corporation (CCPC). The lowest personal income tax rate paid by a proprietorship would range from approximately 20% to 29%, depending on the province/territory. This rate increases with income. Taxable income over $120,887 (in 2007) is taxed at the highest marginal rates, which range from approximately 39% to 48%, depending on the province/territory. See the Marginal Tax Rates page.
A proprietorship has a lack of permanence – if the owner dies, the net business assets pass to the heirs, but valuable leases and contracts may not.
A partnership is also an unincorporated business. It is similar to a proprietorship, except two or more entities are partners in the business. For partners who are individuals, the income from the partnership is taxed at personal income tax rates, and a percentage of the income is included on the personal income tax return of each owner.
Advantages of partnership:
The setup costs of a partnership are relatively low.
A partnership is less regulated than a corporation. A partnership agreement should be drawn up to outline the terms of the partnership, what happens in the event of a dissolution, and what happens in the event of disagreements among partners. In the absence of an agreement, or if certain provisions are not addressed in the agreement, provincial or territorial laws will determine some or all of the terms of the partnership.
Business losses can be written off against other income of the partners.
Broader base of experience, knowledge and skills to draw from.
Disadvantages of a partnership:
The biggest disadvantage of a partnership is unlimited liability. The partners are jointly liable for all debts and other liabilities of the business. If the business is sued, all the business and personal assets of the partners are at risk. An exception to this is a Limited Partnership. Limited Partners, who contribute capital but do not participate in the management of the business, will have their liability limited to the amount of capital that they have contributed. The partners who participate in the management of the business are called General Partners, and will still have unlimited liability.
Decisions must be made jointly.
If the business is profitable, it will usually be paying higher taxes than if it was incorporated as a Canadian controlled private corporation (CCPC). See this same topic above under proprietorships.
The death or retirement of a partner will not end the partner’s liability for debts and obligations of the partnership that were incurred prior to the death or retirement. Also, if a partner retires and does not make the retirement publicly known, he/she could still be held liable for obligations incurred by the partnership after the retirement.
A corporation is a separate legal entity, which is formed by application to either the federal government, or one of the provincial/territorial governments. The corporation issues shares to the owners, or shareholders. The funding of the corporation can be done through the issue of shares, or by borrowing. Instead of investing a large amount in shares, shareholders can lend money to the corporation, and invest only a minimal amount in the shares. This way, when the corporation has available cash, the shareholder loans can be repaid without attracting personal income tax.
Being a separate legal entity, a corporation pays corporate income tax, which is calculated completely separately from the owners’ personal income tax. If the corporation pays wages to the shareholders, income tax and Canada Pension Plan contributions, and sometimes Employment Insurance premiums, must be deducted and remitted to Canada Revenue Agency.
Advantages of incorporation:
One of the biggest advantages of incorporating a business is limited liability. This means that the liability of the shareholders is usually limited to the amount that they have invested in their shares in the corporation. However, many incorporated small businesses are not able to get bank loans without the personal guarantee of the shareholders, so this eliminates part of the advantage of limited liability. The personal assets of the shareholders are protected from lawsuits against the corporation. However, shareholders who are directors of the corporation can be held legally liable for some debts of the corporation (such as GST/HST and payroll taxes) in certain circumstances.
Another major advantage for a profitable small business is the income tax advantage. A Canadian controlled private corporation, or CCPC, pays a much lower rate of federal tax (small business rate) on the first $400,000 (in 2007) of active business income than would be paid by an unincorporated business, due to the small business deduction. Active business income generally does not include investment income or rental income, which is taxed at regular corporate tax rates. The combined federal + provincial small business tax rate varies from approximately 16% to 22%, depending on the province. The threshold amount subject to the lower small business rate also varies between provinces. Keep in mind that this tax advantage is mainly a deferral of taxes until the profits are paid out to the shareholder. If all the profits are paid out to the shareholder as they are earned, leaving the corporation with little or no taxable income, then they will be taxed entirely as income of the shareholder, at personal income tax rates.
Another tax advantage of incorporation is the $750,000 capital gains deduction on the sale of shares of a qualifying small business corporation. One of the qualifications is that the corporation must be a CCPC with active business income.
Private Health Service Plans can be used to provide tax-free benefits to employees. This deduction is also available to sole proprietors and partners, but the treatment for corporations is more favourable than that for unincorporated businesses.
Disadvantages of incorporation:
Incorporation is the business structure with the highest setup and administrative costs.
Incorporation is the most complicated business structure. It is very important to take extreme care in setting up classes of shares, deciding who will be shareholders (spouses, children) and how much control they will have (control is determined by % of voting shares owned). Professional advice can avoid serious problems.
Business losses cannot be written off against other income of the owners (shareholders).
More administrative work is required for a corporation. This includes annual reports filed with the corporate registry, and corporate tax returns which are filed separately from the owners’ personal tax returns.
Generally, the higher the net income of your small business, the more advantageous it is to incorporate instead of remaining as a proprietorship.
No matter what the type of business structure, spouses and children can be employed by the business, thus effectively splitting income. However, amounts expensed must be reasonable amounts based on services provided, and must actually be paid to the spouse and/or children.