One of the first major decisions you will have to make as you start your new business is the form of legal entity it will take. To a large degree, this decision may be dictated by the way you have organized your operations and whether you intend to work on your own or in conjunction with others.

The form of entity you choose can have a significant impact on the way you are protected under the law and the way you are affected by income tax rules and regulations. There are three basic forms of business organizations. Each has its own benefits and drawbacks and is treated differently for legal and tax purposes.

Sole Proprietorship

A sole proprietorship is typically a business owned and operated by one individual. A sole proprietorship is not considered to be a legal entity under the law, but rather is an extension of the individual who owns it. The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred by the business. The income or loss of a sole proprietorship is combined with the other earnings of an individual for income tax purposes.

A sole proprietorship is perhaps the easiest form of business to own and operate because it does not require any specific legal organization, except of course the normal requirements such as licenses or permits. A sole proprietorship typically does not have any rules or operating regulations under which is must function. The business decisions are solely the result of the owner's abilities.

Partnerships

Partnerships can take two legal forms, general or limited. In a general partnership, two or more individuals join together to run the business enterprise. A partnership must usually register with the Joint Stock Registrar in order to operate a business under the partnership name. Each of the individual partners has ownership of company assets and responsibility for liabilities, as well as authority in running the business. The authority of the partners, and the way in which profits or losses are to be shared, can be modified by the partnership agreement. The responsibility for liabilities can also be modified by the agreement among the partners, but partnership creditors typically have recourse to the personal assets of each of the partners for settlement of partnership debts.

A limited partnership is comprised of one or more general partners who are personally liable for partnership debts and one or more limited partners who contribute capital and share in the profits or losses of the business. The limited partners do not take part in running the business and are not liable for the debts of the partnership.

The rights, responsibilities and obligations of both the limited and general partners are typically detailed in a partnership agreement. It is a good idea to have such an agreement for any partnership, whether limited or general.

A partnership is a legal entity recognized under the law, and as such, it has rights and responsibilities in and of itself. A partnership can sign contracts, obtain trade credit and borrow money. When a partnership is small most creditors require a personal guarantee of the general partners for credit.

Corporation

A corporation is a separate legal entity which exists under the authority granted by provincial or federal law. A corporation has substantially all of the legal rights of an individual and is responsible for its own debts. It must also file income tax returns and pay taxes on income it derives from its operations. Typically, the owners or shareholders of a corporation are protected from the liabilities of the business. However, when a corporation is small, creditors often require personal guarantees of the principal owners before extending credit. The legal protection afforded the owners of a corporation can far outweigh the additional expense of starting and administering a corporation.

A corporation must obtain permission from the Registrar of Joint Stocks to do business under a corporate name. A corporation must also adopt and file articles of incorporation and by-laws which govern its rights and obligations to its shareholders, directors and officers.

Corporations must file annual income tax returns with Revenue Canada. Certain other provinces also require corporate returns to be filed (i.e. Quebec and Alberta). Nova Scotia corporate taxes are collected by the federal government; therefore only one return needs to be filed in this province.

Incorporating a business allows a number of other advantages such as the ease of bringing in additional capital through the sale of equity, or allowing an individual to sell or transfer their interest in the business. It also provides for business continuity when the original owners choose to retire or sell their interest.

The decision about whether or not to incorporate your business is a complex one. There are tax issues as well as the liability issue. In the province of Nova Scotia, the corporate income tax rate is 18% for the first $200,000 of income earned by an active business. The personal income tax rate is 28% for the first $30,000 of income, 43% for the next $25,000, and 50% thereafter. (These rates have been rounded.) Therefore the business will pay less tax on its income if it is incorporated. However this only applies to income which is left in the corporation, any amounts withdrawn by the shareholders will be taxed at personal income tax rates.

The conclusion which can be drawn is that it only makes sense from the immediate tax perspective to incorporate once the business is making sufficient income that some of it is being left in the corporation. Otherwise if all income is being removed from the company because the shareholders need the money to live, there is no tax advantage to having the corporation.

This is an example of an issue where professional advisors can be of great assistance.