Every business carries inherent risks. For example, in 2022, the Tim Hortons app faced the risk of violating privacy laws, leading to investigations and potential fines. But who shoulders these risks? This largely depends on the organizational structure of the business. The law governing business organizations establishes a framework for the operation of businesses, emphasizing the relationships between owners, managers, and the business itself. It outlines the rights and responsibilities of owners in managing the business and overseeing those who manage on their behalf. When management acts against the best interests of the business, the law provides remedies for business owners. In this way, business organization law helps address the risks owners face due to managerial actions.
We will examine four types of Canadian business entities:
- Sole proprietorship
- General partnership
- Limited partnership
- Corporation
Understanding these different structures can help you make informed decisions about how to organize and manage your business effectively, minimizing risks and maximizing success. In this article, we will delve into each of these business entities, exploring their unique advantages, disadvantages, and implications for risk management. By understanding how the right business structure can protect your interests, you can better position your business for growth and stability.
Sole Proprietorship
Definition of Sole Proprietorship
The sole proprietorship is the simplest form of business organization. It comes into existence when a person starts to carry on business on their own, without adopting any other form of business organization, such as a corporation. For example, if you start a freelance graphic design business, you are carrying on business as a sole proprietor.
As a sole proprietor, you could enter into a contract to employ someone else to help with your design projects, but you remain the sole owner of the business and the only person responsible for its obligations. Both legally and practically, there is no separation between the sole proprietorship business organization and the individual who is the sole proprietor. A sole proprietor cannot be an employee of the business because you cannot contract with yourself.
Advantages of Sole Proprietorship
- Simplicity and Ease of Setup: The main advantage of a sole proprietorship is its simplicity and ease of setup. It is equally easy to dissolve: the sole proprietor simply stops carrying on the business.
- Control: The sole proprietor gets all the benefits and bears all the burdens of the business. This includes full control over decision-making and operations.
- Tax Simplicity: For income tax purposes, the income or loss from the sole proprietorship is taxed in the hands of the sole proprietor.
Disadvantages of Sole Proprietorship
- Unlimited Personal Liability: The main disadvantage of a sole proprietorship is unlimited personal liability. This means that third parties may take all the sole proprietor’s personal assets—not just those of the business—to satisfy the business’s obligations.
- Limited Financing Options: Raising money can be challenging. Since it is not possible to divide up ownership of the sole proprietorship, the only method of financing is for the sole proprietor to borrow money directly.
- Risk Management: As the scale of the business and the related liabilities increase, managing the risk becomes more difficult. Incorporation often becomes a more attractive option as the business grows.
Legal Requirements for Sole Proprietorships
- Registration: The name of a sole proprietorship must be registered if that name is something other than, or more than, the proprietor’s personal name. For example, if Jessica Brown starts a pet grooming business under the name “Jessica Brown” she wouldn’t need to register. However, if she uses the name “Paws and Claws Grooming” or “Jessica Brown Paws and Claws Grooming” registration is required. Registration must be completed in every province or territory in which the sole proprietorship carries on business. Registration does not create any ownership interest in the business name, but the sole proprietor’s interest may be protected under provincial passing-off laws and federal trademarks law.
- Business License: A business license is necessary for some types of activities. A business license is government permission to operate a certain kind of business. For example, most municipalities may require home-based catering businesses and beauty salons to obtain licenses. Provincial governments have enacted licensing requirements for many types of businesses, including financial advisors, construction contractors, and daycare providers. Licensing is used to ensure that certain standards are met by businesses engaged in the licensed activities.
- Regulatory Requirements: Sole proprietors are subject to the same regulatory requirements as businesses carried on by any other form of business organization, such as labor and environmental standards. For instance, a sole proprietor running a small manufacturing operation must adhere to the same environmental regulations as a larger corporation in the same industry.
Definition of General Partnerships
A general partnership is a business organization that comes into existence when two or more people conduct business together with the intention of making a profit. This type of partnership arises automatically by law when a relationship meeting these criteria begins. No formalities may be required, although the partnership may need to register its name and obtain a business license. In Ontario, general partnerships are governed by the General Partnership Act. For instance, if you and a friend agree to start a landscaping business, share the responsibilities, and split the profits, you have created a general partnership.
Advantages of General Partnerships
- Resource Pooling: Individuals can combine their resources, knowledge, and skills to pursue a common business goal.
- Shared Profits: All benefits of the partnership business accrue directly to the partners.
- Ease of Formation: General partnerships can be formed automatically without the need for formalities, although registration and licenses may be required.
Disadvantages of General Partnerships
- Unlimited Personal Liability: All partners, even those who did not consent to a particular obligation, are personally liable for all the obligations of the business. This includes torts committed by a partner or an employee of the partnership in the course of the partnership’s business. All of a partner’s personal assets—not just those committed to the business—may be seized to satisfy a partnership obligation.
- Employment Restrictions: A partner cannot be employed by the partnership.
- Risk of Dissolution: The partnership can be easily dissolved if one partner gives notice of termination, dies, or becomes insolvent, or if the partnership was established for a specific purpose or limited time and that purpose or time has expired.
Definition of Limited Partnerships
A limited partnership is a special form of partnership recognized in all jurisdictions in Canada. It allows individuals to become partners while avoiding unlimited personal liability, provided they restrict their involvement in the partnership business. In a limited partnership, there must be at least one general partner with unlimited liability and at least one limited partner whose liability is limited to the amount of their investment. Limited partnerships come into existence only when a limited partnership declaration is filed with the appropriate provincial government authority.
Advantages of Limited Partnerships
- Limited Liability: Limited partners have their liability capped at the amount of their investment. For example, if you invest $10,000 as a limited partner, your maximum liability is $10,000, regardless of the partnership’s debts.
- Attractive to Investors: Limited partnerships are appealing to passive investors who want to share in the profits and deduct partnership losses against other income for tax purposes.
Disadvantages of Limited Partnerships
- Formation Requirements: A limited partnership only comes into existence after a limited partnership declaration is filed, unlike a general partnership which forms as soon as business activities commence. In Ontario, these partnerships are governed by the Limited Partnerships Act.
- Control Restrictions: Limited partners lose their limited liability status if they participate in controlling the business or if their names are used in the firm name. For example, if a limited partner starts making major business decisions, they could become personally liable for the partnership’s obligations.
- Complexity in Roles: It can be difficult to distinguish between providing management advice and controlling the business.
Overall, limited partnerships offer a balanced structure for individuals who want to invest in a business without taking on unlimited personal liability, provided they adhere to the rules and restrictions governing their involvement.
Definition of Corporations
A corporation is the most common form of business organization, used for all types and sizes of businesses, from one-person operations to large multinationals. Unlike sole proprietorships and general partnerships, corporations do not come into existence simply because one or more people start doing business. A corporation is created only when certain documents are filed with the appropriate government office under either the federal Canada Business Corporations Act (CBCA) or similar legislation in each province or territory. Once incorporated, the company is governed by the laws of the jurisdiction where incorporation occurred.
Advantages of Corporations
- Limited Liability: Shareholders of a corporation have limited liability, meaning they are not personally responsible for the debts and obligations of the corporation beyond their investment in shares.
- Separate Legal Entity: A corporation is a separate legal entity from its owners, which means it can own property, enter into contracts, sue, and be sued in its own name.
- Perpetual Existence: Corporations have perpetual existence, meaning they continue to exist even if the ownership changes or if shareholders die or leave the company.
- Ease of Raising Capital: Corporations can raise capital more easily than other business forms by issuing shares of stock to investors.
- Transferability of Ownership: Ownership in a corporation is easily transferable through the buying and selling of shares.
Disadvantages of Corporations
- Complex Formation Process: Incorporating a corporation requires filing specific documents with the government and adhering to various legal requirements, which can be more complex and costly compared to forming a sole proprietorship or partnership. A business lawyer is often required for the formation of corporations.
- Regulatory Requirements: Corporations are subject to more regulatory requirements and ongoing compliance obligations, such as maintaining corporate records, filing annual reports, and holding shareholder meetings.
- Double Taxation: In some jurisdictions, corporations may face double taxation, where the corporation’s profits are taxed at the corporate level and then again at the individual level when distributed as dividends to shareholders.
Legal Requirements for Corporations
- Incorporation Documents: To incorporate a corporation, the following documents must be filed with the appropriate government office:
- Articles of incorporation
- A name search report on the proposed name of the corporation
- The required fee
The articles of incorporation set out the fundamental characteristics of the corporation, such as its name, the class and number of shares authorized to be issued, the number of directors, any restriction on transferring shares, and any restriction on the business that the corporation may conduct. The name search report ensures that the proposed name is not confusingly similar to an existing business name or trademark.
Choosing the Right Business Structure: Key Takeaways and Legal Consideration
Every business carries inherent risks, which are largely influenced by the organizational structure chosen. Whether you choose a sole proprietorship, general partnership, limited partnership, or corporation, the law governing business organizations provides a framework to manage the relationships between owners, managers, and the business itself. This framework helps mitigate risks by outlining the rights and responsibilities of those involved.
Understanding the advantages and disadvantages of each business structure is important for making informed decisions that minimize risks and maximize success. Sole proprietorships offer simplicity and control but come with unlimited personal liability. General partnerships allow resource pooling and shared profits but also carry the burden of unlimited liability. Limited partnerships provide limited liability to passive investors but require careful adherence to control restrictions. Corporations offer limited liability, perpetual existence, and ease of raising capital, yet they involve a more complex formation process and stringent regulatory requirements. It is always advisable to consult a legal professional when forming your legal entity.
About the Author
Roberts & Obradovic is a Toronto-based law firm specializing in corporate, privacy, employment, and litigation matters. Our experienced team provides comprehensive legal guidance on various business structures, helping clients understand the implications of sole proprietorships, partnerships, and corporations.
