When preparing to launch your business, one of the most important decisions that you’ll have to make is what type of legal and tax structure it will have to best support your goals. What you choose must comply with tax law, so it’s important to fully understand the differences between each type of structure to avoid any accidental oversights or pitfalls.
The three types of legal business tax structures that we will be exploring are:
- sole proprietorship
- partnership
- incorporation
Sole Proprietorship Tax Structure
In a sole proprietorship, you are the exclusive owner of your company. In the eyes of legal and tax authorities, you and your business are synonymous with each other which means the business’s financial responsibilities fall on you alone.
This allows for a great deal of flexibility when it comes to scaling operations up or down, depending on your needs.
From a taxation standpoint, you’ll pay personal income tax on your business’ earnings, minus business expenses, and any contributions made to your Canada Pension Plan (CPP) and Employment Insurance (EI). You can also claim personal tax deductions, such as RRSP deductions, to lower your annual tax rate. It’s also worth noting that you’ll declare your business income on your personal income tax form – meaning you only have to complete one tax submission instead of two.
Sole proprietorship offers more flexibility to proprietors though it does have some risks to be aware of. In this structure, the proprietor is personally liable for all events and debts associated with their business. This means that your personal assets are directly linked with your business which puts them at risk if you were to default on any debt. All responsibility associated with a sole proprietorship falls to you – so making sure you’re doing your due diligence when it comes to you legal and financial obligations is key.
Partnership Tax Requirements
A partnership is very similar to a sole proprietorship but instead of only having one proprietor, there are multiple. Ideally, your partner(s) will bring knowledge, skills, and capabilities that compliment your own and will help the business thrive as a whole.
Partners should establish contractual agreements with each other that detail how revenues, expenses, and responsibilities will be shared. This should be established using percentages so that a numerical value can be applied to each proprietor’s income and expenses when tax season comes around.
Partners are only required to pay personal income taxes on their share of the profits from the business. Keep in mind that, as partners, you each become personally liable for any debt associated with the business. That includes those obligations that were entered into by any of the business partners – not just you.
As well, if your partner wants out of the business but you want to keep it, you’ll have to buy them out which can be a costly endeavor. Ensure that you have a dissolution strategy in place to minimize additional costs and prevent ‘he said, she said’ arguments. Much like a prenuptial agreement, a dissolution strategy lays out the terms of your business partnership and what happens in the case that it isn’t working out. You hope that you never need it, but it can save you a lot of time, grief, and money if you do.
Incorporation Tax Obligations
Incorporation is the process in which a distinct legal entity, owned by shareholders, is created. Unlike sole-proprietorship or partnerships, a corporation stands independent from the owner(s) and doesn’t integrate its liability or income taxes with them.
Formal ownership shares produce legal distinction between the company and its shareholders, which has several tax advantages for the owners. An incorporated business can cash in on business tax rates, which are significantly lower than personal tax rates, by deferring and/or saving them.
Incorporation also provides some liability protection for debts incurred by the company as long as you can find a willing lender. For maximum benefit and security, it’s recommended that you wait until your earning reach $80,000 per year before incorporating. If you do decide to go down this route, you must register your business, keep detailed financial records, and report your finances yearly. Your financial statements must be audited annually by chartered accountants.
Keep in mind that these financial and taxation requirements will incur ongoing costs such as legal and accounting fees, as well as those associated with managing additional administrative tasks, corporate tax instalments, and maintaining separate bank accounts.
Charging GST for All Tax Structures
No matter what kind of legal business or tax structure you decide upon, you have certain legal obligations that must be met: one of which is charging GST when you start to earn over a certain amount from goods and/or services that are considered taxable. The CRA deems any business with $30,000 or less in revenue to be a small supplier. Under this title, you do not need to register with the CRA for a business number or collect GST.
You are also excused from charging GST if your business sells goods and/or services that are considered exempt by the CRA such as groceries, medical supplies, childcare, etc. If your profits exceed $30,000 while providing taxable goods and/or services, you must charge GST and register with the CRA for a business number. At the end of your filing season, you can claim an input credit for the taxes you collected during that quarter.
Have Tax Structuring Questions? IAPC Can Help!
What business tax structure to choose is a complicated decision that should only be made after considerable research and planning. It’s important to consider what you want to establish as a business, and plan accordingly with a professional that supports your ambitions and can help you avoid any potential pitfalls. You can read more about all legal and tax structures on the Canada Revenue Agency website.
Contact us today to discuss any questions that you may have – we’re happy to guide you through this next chapter of your business.
