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Ask the Expert: Business Structure & Protection of Personal Assets

By Michael Fromstein |

Dave asked:

I am aware that to register a business as a corporation is more complicated than as with partnerships and sole proprietorships, but how exactly? Also, concerning financial risks with corporations, is the entrepreneur personally liable for an outstanding startup bank loan should the business fail?

Michael Fromstein answered:

Dave's first question was: Registering a business as a corporation is more complicated than as partnerships and sole proprietorships, but how exactly?

"1. Sole Proprietorship
A sole proprietorship is a business owned and operated by one individual. It is not considered to be a legal entity under the law, but rather is an extension of the individual who owns it and therefore does not require any specific legal organisation, except of course, the normal requirements such as licenses or permits. The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred by the business. Any loans of the proprietorship are identical to personal loans of the individual. The income or loss of a sole proprietorship is combined with the other earnings of an individual for income tax purposes.

2. Partnerships
A partnership is a relationship between persons carrying on a profit-motivated business in common. That is, a defining characteristic of a partnership is that there must be more than one person involved in the business. Any number of individuals operating a business in common can establish a general partnership without any government approval. A general partnership is created by the partners and is routinely registered with the government within 60 days of creation. Registration is relatively easy and primarily involves paying a fee to the government. Determining and documenting the rights and obligations of the partners is much more involved. These rights, responsibilities and obligations are typically detailed in a partnership agreement. It is a good idea to have such an agreement for any partnership. 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. Any partner is responsible for all liabilities of the partnership. Creditors often "go after" the wealthier partners first when the partnership does not pay its obligations. When a partnership is small creditors may require a personal guarantee of the partners before granting credit. A partnership does NOT have to file income tax returns or pay income tax. The financial information from the partnership is combined with the personal income of the partners to determine their overall tax liability. Partnerships with more than FIVE partners have to comply with Revenue Canada's reporting requirements.

3. Corporation
A corporation is a separate legal entity which exists under the authority granted by either 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 most of the liabilities of the business. However, when a corporation is small, creditors may and almost all banks will 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.
Corporations must file annual income tax returns with the Revenue Canada (federal) and the Ministry of Finance (provincial) and possibly other provinces in which it does business.
Legal fees for incorporating commonly run from $ 500 to $ 1,000, and government fees, vary depending on provincial ($ 315 in Ontario) or federal ($ 500 ) incorporation."

Dave's second question was: Does one form of operation provide more protection from creditors, that is is the entrepreneur personally liable for an outstanding startup bank loan should the business fail?

"In practice, there is no practical protection for the small business person from the banks. There is initial legal protection only when the business operates from a corporation. However, because banks do not want to assume the risks of carrying on the business when the owner assumes the benefits, banks virtually always require a personal guarantee from small businesses. All the assets of the guarantor are available to the bank to settle the original debt, regardless of whether or not the original loan was to a sole proprietor, partnership or corporation.

There is additional information on this and related subjects in the business resource library at our web site. Much of the above content is contained in our booklet "Starting Your Own Business" {in English and French} in the "Business" section of the Canadian portion of our library."

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