Business Law

I am the sole proprietor of a profitable construction business that I want to expand. I’m nervous about the risk associated with the business and its expansion. Should I incorporate?

We would strongly recommend incorporation. Incorporation provides you with limited liability to protect your personal assets from creditors, and tax advantages that will help you grow your business and your wealth.

‍Limited Liability

‍A corporation is a legal entity distinct from its shareholders. The obligations, debts and liabilities of the business are those of the corporation and not of its shareholders. The protection from creditors is a significant advantage, particularly for businesses that are inherently risky. As the sole proprietor you are currently liable for every debt, liability, obligation and claim against your business. In your construction business, an inadvertent error or mistake by a sub-contractor, or simply the failure of the project caused by others, could result in huge liabilities for which you are personally exposed to creditors, risking loss of your house, savings and other assets. Incorporation of your business creates a significant barrier of protection. (Note: there are statutory and other limited exceptions to the protection provided by a corporation)

‍Income Taxes

‍Active business income earned by a corporation is taxed at a much lower tax rate, approximately 15.5% in Ontario on income up to the small business limit of $500,000. This presents two wealth planning opportunities. Firstly, a growing business requires working capital. As a sole proprietorship, growing working capital is hard because profits are taxed at your personal marginal rate of taxation which may be in excess of 50%. By incorporating, you can grow your working capital, and thus expand your construction business, at a much faster rate because of the low rate of corporate tax. Secondly, by leaving profits in the Corporation in excess of your personal needs, you can grow your retirement savings in the corporation at a much faster rate. (In subsequent publications, we will talk about how to creditor-proof these savings).

‍Tax Splitting

‍A corporation provides for legal tax splitting with members of your family, if they are made shareholders of your corporation. The shares of your corporation may be structured so that you remain in control of the corporation notwithstanding shares issued to family members.

My friend and I have an idea for a business and we are considering forming a partnership. How does a partnership work and how should one be setup?

Whether or not a partnership exists is a fundamentally a legal question. Ontario’s Partnerships Act says that a relationship between “persons carrying on a business in common with a view to profit” is a partnership within the meaning of the Act. This is important because it means that whether or not you declare yourself to be a partnership, legally speaking, you might be a partnership anyways, whether you intended to or not.

A partnership can exist between you and your friend personally, or even as between two corporations controlled by each of you. Unlike a corporation, however, a partnership has no separate legal existence from the partners themselves and each partner has the power to bind the partnership and each partner is jointly liable for any obligations incurred on behalf of the firm. This is why, when deciding to form a partnership, a partnership agreement can be very practical.

A partnership agreement sets out the rights and obligations for partners in the partnership and provides for what should happen in circumstances of partnership incapacity, retirement or death. Without one, the Partnerships Act will provide for what happens to the partnership in these circumstances, often with unintended results. A partnership agreement can also provide mechanisms for the distribution of partnership income and a process for bringing additional persons into the partnership. Creating a partnership agreement that meets your goals with the help of a commercial Lawyer ensures that your partnership will continue in a manner of your design.

My husband and I are the sole shareholders and directors of an incorporated retail business. We have been quite successful and are generating cash excess to business requirements. We do not want to pay the cash out to ourselves now, and pay high rates of tax, but at the same time this cash is a significant part of a retirement fund. We have no creditors, other than trade creditors payable in the ordinary course. How do we protect this cash for our retirement?

‍You are asking a good question. In the event of an unexpected economic downturn or legal claim against your active business corporation, the excess cash generated in the business could be exposed to potential creditors. Once the liability is crystalized, it may be too late to take action that will protect the cash. You have also correctly identified that the simplest solution –payment of the cash out to yourselves – attracts undesirable tax consequences.

A cost efficient solution is the creation of a holding corporation. The holding corporation structure, when designed properly, allows excess money from your active business corporation to be paid by dividend to the holding corporation, tax free. The holding corporation is a separate legal entity, and is generally insulated from claims against your active business corporation.

Care is required that the desired tax treatment is achieved in the structuring of the holding corporation. There are other financial planning considerations, such as ensuring the availability of the lifetime capital gains exemption, which must be addressed by the new structure. This type of corporate structuring may also be implemented as part of a broader strategy for business succession and included as part of your estate planning.