This blog post covers the 3 primary considerations small business owners should have when trying to decide if it’s time to incorporate.
*Disclaimer: this guide is for informational purposes only. It does not constitute legal advice nor create a solicitor-client relationship between the author and reader. As with all legal matters, a lawyer should be properly retained and consulted where legal advice may reasonably be considered necessary.
Should I Incorporate My Business?
This blog post provides an overview of the 3 main benefits of of incorporating your Ontario small business including:
1. Reducing or Limiting Liability
2. Structural Flexibility
3. Tax Advantages
Note: this post applies only to private corporations organized under the Ontario Business Corporations Act or Canada Business Corporations Act.
Ready? Here we go!
1. Reducing Liability
Liability for Sole Proprietors
If you’re a sole proprietor (the default if you are not incorporated and are not operating your business with a partner) you are personally accountable for the debts and liabilities of your business. This is true even if you are operating under a trade name (or multiple trade names if you have different businesses). Personal liability as a sole proprietor means your creditors, or a party with a successful judgment against your business, can look to your personal assets (like your home) to recover any monetary compensation to which they may be entitled. The inverse holds true as well, meaning if you are found personal liable for some debt or fault of your own, your business assets will be exposed.
Creating a Separate Legal Entity
Incorporation creates a separate legal entity to distance you from your business. This is the defining feature of a business corporation and is true even if the corporation is owed by a single person. As a separate entity, a corporation can acquire, enjoy, and enforce, legal rights apart from the individuals that control it. So, if your business is incorporated and fails to pay its invoices (or is sued for negligence) a party with a successful claim against your business can only look to the assets of the corporation for recovery.
Limited Liability Doesn’t Mean Unlimited Liability
Corporations have a hierarchical structure that creates different duties and liabilities for its internal actors. At the top of the corporation is a board of directors that manages the business affairs of the corporation. The board of directors is elected through a vote by the corporation’s shareholders. With small or closely held corporations, directors and shareholders are often the same people or the same person. While the corporation is a separate entity for legal purposes, directors and shareholders can attract personal liability based on their conduct in managing the corporation. In particular, if a corporation is being used as a vehicle for fraud, it is possible for the courts to “pierce the corporate veil” and hold directors or shareholders personally liable (though this is a rare and extraordinary remedy).
Directors
Directors owe a duty of good faith to the corporation. As a fiduciary, they must act in the corporation’s best interests and with reasonable care and diligence. Directors may be personally liable to the corporation (and by extension the shareholders) for breaching their duties to the corporation, but will generally not attract personal liability when lawfully managing the corporation’s affairs.
Shareholders
For shareholders of the corporation, liability is generally limited to the proportional interest (or share) they hold in the corporation. That is to say, if the corporation was dissolved tomorrow, what their shares would be worth after a corporate accounting. However, shareholders can be liable to repay creditors from property they received when the corporation was insolvent, or to a minority shareholder if the majority’s conduct was unfairly prejudicial to them.
Unanimous Shareholder Agreements
Shareholders can agree to enter into a unanimous shareholder agreement (USA) which has the effect of transferring the power to manage the corporation from the directors to the shareholders. USAs are common in small corporations where the shareholders and directors are the same people, Without a USA, shareholders only govern the affairs of the corporation indirectly by electing directors that align with their vision for the corporation and voting to remove directors whose decisions they disagree with. By using a USA, shareholders can become liable to the same extent as directors depending on the powers they have agreed to assume.
2. Structural Flexibility
Organizational Freedom
Another benefit of incorporation is the organizational freedom this business vehicle provides. For instance, unless you set restrictions on the type of business your corporation can carry on, your corporation can engage in whatever lawful profit-making activities the directors may choose.
Corporations are free to partner with other corporations (or individuals) by entering into a formal partnership agreement or carrying on business with another party with a view to profit. Corporations can also pursue business opportunities with limited temporal durations by forming a joint venture. A corporation can have affiliates, parent organizations, and can even issue shares to another corporation to make it a shareholder (this is a common technique where profits are paid to a holding corporation in the form of dividends).
Directors’ Freedom to Act
While your corporation must have at least one director (even if the shareholders enter a USA), and at least 25% of the board must be compromised of Canadian residents, there are few other external limitations that may apply to how your corporation is governed.
There is no maximum number of directors your corporation can have, constraint on their length of service, skills they must possess, prohibition on holding shares, or limits on a director’s decision-making authority (other than the duties discussed above). All of these issues can (and should) be fine tuned in the corporation’s bylaws (which are not public). Generally, only public companies must make their financial statements public. Federal and provincial statutes permit shareholders of private corporations to dispense with the requirement for audited financial statements.
Ability to Issue Shares
The ability to issue shares is another primary benefit to incorporation. By issuing shares, a corporation can attract investors hoping to share in the profits of the corporation in the form of dividends, or any capital remaining if the corporation is wound-up.
Your corporation must have at least one class of shares. Where there is only one class of shares, those shares must be equal in all respects and possess the following characteristics:
- The ability to vote to elect the board of directors
- The right to receive a proportionate share of the corporation’s property on dissolution
- And for federally incorporated businesses, the right to receive dividends
However, where you have more than one class of shares, you can distribute these rights across your share classes however you see fit. For instance, if you have 2 share classes they can be structured as follows:
A Class Shares – voting rights only
B Class Shares – the right to share in the corporation’s assets on dissolution and the right to receive dividends
As long your corporation’s shares possess the minimum characteristics (which again, differ depending on which jurisdiction you incorporate under), the type and amount of shares a corporation may issue are generally only limited by the corporation’s internal organizing documents.
3. Tax Advantages
In general, the main tax advantages that come with incorporation are a flat corporate tax rate (as opposed to progressive taxation for individuals) and the ability to choose how and when income is earned through the corporation – the latter being beneficial for personal and corporate tax planning purposes. Depending on the situation, you may choose to draw income from the corporation in the form of an annual salary or through dividends. You may also decide its better for taxation reasons to reinvest corporate profits back into the business instead of withdrawing them from the company at that time.
For most sole proprietors in the early growth stages, incorporation may not be all that advantageous for tax purposes. But, as your business grows, incorporation is likely something your accountant will recommend and who you should be seeking your tax planning advice from.
Conclusion
If you’re wondering whether incorporation is the right choice for your small business, liability, structural flexibility, and tax advantages should be your primary considerations. If it’s too soon to incorporate, you can still reduce your liability (in part) by using properly drafted contractual arrangements.
