Factors to Consider When Starting a New Business
If you’re starting a new business, you have to decide which legal form of ownership is best for you and your business. Do you want to own the business yourself and operate as a sole proprietorship? Or, do you want to share ownership, operating as a partnership or a corporation? Before we discuss the pros and cons of these three types of ownership, let’s address some of the questions that you’d probably ask yourself in choosing the appropriate legal form for your business.
- In setting up your business, do you want to minimize the costs of getting started? Do you hope to avoid complex government regulations and reporting requirements?
- How much control would you like? How much responsibility for running the business are you willing to share? What about sharing the profits?
- Do you want to avoid special taxes?
- Do you have all the skills needed to run the business?
- Are you likely to get along with your co-owners over an extended period of time?
- Is it important to you that the business survive you?
- What are your financing needs and how do you plan to finance your company?
- How much personal exposure to liability are you willing to accept? Do you feel uneasy about accepting personal liability for the actions of fellow owners?
No single form of ownership will give you everything you desire. You’ll have to make some trade-offs. Because each option has both advantages and disadvantages, your job is to decide which one offers the features that are most important to you. In the following sections, we’ll compare three ownership options (sole proprietorship, partnership, corporation) on these eight dimensions.
Sole Proprietorship and Its Advantages
In a sole proprietorship, you make all important decisions and are generally responsible for all day-to-day activities. In exchange for assuming all this responsibility, you get all the income earned by the business. Profits earned are taxed as personal income, so you don’t have to pay any special federal and provincial income taxes.
Disadvantages of Sole Proprietorships
For many people, however, the sole proprietorship is not suitable. The flip side of enjoying complete control is having to supply all the different talents that may be necessary to make the business a success. And when you’re gone, the business dissolves. You also have to rely on your own resources for financing: in effect, you are the business and any money borrowed by the business is loaned to you personally. Even more important, the sole proprietor bears unlimited liability for any losses incurred by the business. The principle of unlimited personal liability means that if the business incurs a debt or suffers a catastrophe (say, getting sued for causing an injury to someone), the owner is personally liable. As a sole proprietor, you put your personal assets (your bank account, your car, maybe even your home) at risk for the sake of your business. You can lessen your risk with insurance, yet your liability exposure can still be substantial. Given that Ben and Jerry decided to start their ice cream business together (and therefore the business was not owned by only one person), they could not set their company up as a sole proprietorship.
A partnership (or general partnership) is a business owned jointly by two or more people. About 10 percent of U.S. businesses are partnerships  and though the vast majority are small, some are quite large. For example, the big four public accounting firms, Deloitte, PwC, Ernst & Young, and KPMG, are partnerships. Setting up a partnership is more complex than setting up a sole proprietorship, but it’s still relatively easy and inexpensive. The cost varies according to size and complexity. It’s possible to form a simple partnership without the help of a lawyer or an accountant, though it’s usually a good idea to get professional advice.
Professionals can help you identify and resolve issues that may later create disputes among partners.
Provincial and federal governments also support small businesses and offer free resources as well as opportunities for funding. Canada Business Network (@canadabusiness #SMEPME) is a collaborative arrangement among federal departments and agencies, provincial and territorial governments, and not-for-profit entities.
It offers webinars and other learning events across the country. For example, Ontario’s Small Business Access, offers workshops, a helpline, funding, and provides up-to-date information on legal requirements.
The Partnership Agreement
The impact of disputes can be lessened if the partners have executed a well-planned partnership agreement that specifies everyone’s rights and responsibilities. The agreement might provide such details as the following:
- Amount of cash and other contributions to be made by each partner
- Division of partnership income (or loss)
- Partner responsibilities—who does what
- Conditions under which a partner can sell an interest in the company
- Conditions for dissolving the partnership
- Conditions for settling disputes
Unlimited Liability and the Partnership
A major problem with partnerships, as with sole proprietorships, is unlimited liability: in this case, each partner is personally liable not only for his or her own actions but also for the actions of all the partners. If your partner in an architectural firm makes a mistake that causes a structure to collapse, the loss your business incurs impacts you just as much as it would him or her. And here’s the really bad news: if the business doesn’t have the cash or other assets to cover losses, you can be personally sued for the amount owed. In other words, the party who suffered a loss because of the error can sue you for your personal assets. Many people are understandably reluctant to enter into partnerships because of unlimited liability. Certain forms of businesses allow owners to limit their liability. These include limited partnerships and corporations.
The law permits business owners to form a limited partnership which has two types of partners: a single general partner who runs the business and is responsible for its liabilities, and any number of limited partners who have limited involvement in the business and whose losses are limited to the amount of their investment.
Advantages and Disadvantages of Partnerships
The partnership has several advantages over the sole proprietorship. First, it brings together a diverse group of talented individuals who share responsibility for running the business. Second, it makes financing easier: the business can draw on the financial resources of a number of individuals. The partners not only contribute funds to the business but can also use personal resources to secure bank loans. Finally, continuity needn’t be an issue because partners can agree legally to allow the partnership to survive if one or more partners die.
Still, there are some negatives. First, as discussed earlier, partners are subject to unlimited liability. Second, being a partner means that you have to share decision-making, and many people aren’t comfortable with that situation. Not surprisingly, partners often have differences of opinion on how to run a business, and disagreements can escalate to the point of jeopardizing the continuance of the business. Third, in addition to sharing ideas, partners also share profits. This arrangement can work as long as all partners feel that they’re being rewarded according to their efforts and accomplishments, but that isn’t always the case. While the partnership form of ownership is viewed negatively by some, it was particularly appealing to Ben Cohen and Jerry Greenfield. Starting their ice cream business as a partnership was inexpensive and let them combine their limited financial resources and use their diverse skills and talents. As friends, they trusted each other and welcomed shared decision-making and profit-sharing. They were also not reluctant to be held personally liable for each other’s actions.
A corporation (sometimes called a regular or C-corporation) differs from a sole proprietorship and a partnership because it’s a legal entity that is entirely separate from the parties who own it. It can enter into binding contracts, buy and sell property, sue and be sued, be held responsible for its actions, and be taxed. Once businesses reach any substantial size, it is advantageous to organize as a corporation so that its owners can limit their liability. Corporations, then, tend to be far larger, on average, than businesses using other forms of ownership. Most large well-known businesses are corporations, but so are many of the smaller firms with which likely you do business.
Ownership and Stock
Corporations are owned by shareholders who invest money in the business by buying shares of stock. The portion of the corporation they own depends on the percentage of stock they hold. For example, if a corporation has issued 100 shares of stock, and you own 30 shares, you own 30 percent of the company. The shareholders elect a board of directors, a group of people (primarily from outside the corporation) who are legally responsible for governing the corporation. The board oversees the major policies and decisions made by the corporation, sets goals and holds management accountable for achieving them, and hires and evaluates the top executive, generally called the CEO (chief executive officer). The board also approves the distribution of income to shareholders in the form of cash payments called dividends.
Benefits of Incorporation
The corporate form of organization offers several advantages, including limited liability for shareholders, greater access to financial resources, specialized management, and continuity.
The most important benefit of incorporation is the limited liability to which shareholders are exposed: they are not responsible for the obligations of the corporation, and they can lose no more than the amount that they have personally invested in the company. Limited liability would have been a big plus for the unfortunate individual whose business partner burned down their dry-cleaning establishment. Had they been incorporated, the corporation would have been liable for the debts incurred by the fire. If the corporation didn’t have enough money to pay the debt, the individual shareholders would not have been obligated to pay anything. They would have lost all the money that they’d invested in the business, but no more.
Incorporation also makes it possible for businesses to raise funds by selling stock. This is a big advantage as a company grows and needs more funds to operate and compete. Depending on its size and financial strength, the corporation also has an advantage over other forms of business in getting bank loans. An established corporation can borrow its own funds, but when a small business needs a loan, the bank usually requires that it be guaranteed by its owners.
Because of their size and ability to pay high sales commissions and benefits, corporations are generally able to attract more skilled and talented employees than are proprietorships and partnerships.
Continuity and Transferability
Another advantage of incorporation is continuity. Because the corporation has a legal life separate from the lives of its owners, it can (at least in theory) exist forever.
Transferring ownership of a corporation is easy: shareholders simply sell their stock to others. Some founders, however, want to restrict the transferability of their stock and so choose to operate as a privately-held corporation. The stock in these corporations is held by only a few individuals, who are not allowed to sell it to the general public.
Companies with no such restrictions on stock sales are called public corporations; stock is available for sale to the general public.
Drawbacks to Incorporation
Like sole proprietorships and partnerships, corporations have both positive and negative aspects. In sole proprietorships and partnerships, for instance, the individuals who own and manage a business are the same people. Corporate managers, however, don’t necessarily own stock, and shareholders don’t necessarily work for the company. This situation can be troublesome if the goals of the two groups differ significantly.
Managers, for example, are often more interested in career advancement than the overall profitability of the company. Stockholders might care more about profits without regard for the well-being of employees. This situation is known as the agency problem, a conflict of interest inherent in a relationship in which one party is supposed to act in the best interest of the other. It is often quite difficult to prevent self-interest from entering into these situations.
Another drawback to incorporation—one that often discourages small businesses from incorporating—is the fact that corporations are more costly to set up. When you combine filing and licensing fees with accounting and attorney fees, incorporating a business could set you back by $1,000 to $6,000 or more depending on the size and scope of your business. Additionally, corporations are subject to levels of regulation and governmental oversight that can place a burden on small businesses. Finally, corporations are subject to what’s generally called “double taxation.” Corporations are taxed by the federal and provincial governments on their earnings. When these earnings are distributed as dividends, the shareholders pay taxes on these dividends. Corporate profits are thus taxed twice—the corporation pays the taxes the first time and the shareholders pay the taxes the second time.
The Canadian Comparison
“Incorporation: Tax savings, but more paperwork”, a 2017 article in The Globe and Mail, puts incorporation into the Canadian perspective:
In Ontario, an incorporated business pays a tax rate of 15 per cent on the first $500,000 of income each year, thanks to the small business tax deduction, and 26.5 per cent for anything beyond that. Rates vary by province. A lower tax rate is one of the key advantages to incorporating a business. However, accountants make the distinction that the taxes aren’t being saved, but instead deferred. That’s because, when the money is taken out of the corporation for personal use, through salary or dividends, the individual winds up paying approximately the same tax rate as if they were a sole proprietor. It’s known as the “theory of integration” in the Canadian tax system.
Most accountants recommend business owners incorporate if they can afford to leave money in the company longer-term with the goal of watching the value of the assets grow.
Another tax advantage comes when it’s time to sell the business. The shares of most Canadian private corporations are eligible for a lifetime capital-gains exemption. In 2016, that exemption amounts to the first $824,176 of capital gains from personal income tax, per shareholder. If the business were a sole proprietorship, any gain from the sale of a private corporation would be taxed.
Another advantage to incorporating is the opportunity to use income splitting among family members. If one spouse makes more money, you can income-split. Over all, both spouses will be in a lower income-tax bracket.
Another advantage of incorporation, beyond taxes, is the ability to shift liability to the corporation and away from the individual. Incorporating can also add credibility; some larger companies require contractors to be incorporated before they can be hired.
The disadvantages to incorporation are increased paperwork and administration. That includes the one-time cost to set up the corporation, including accounting and legal fees, which can run to more than $1,000. Owners also have to file two tax returns, a personal one and a more complicated one for the business.
Five years after starting their ice cream business, Ben Cohen and Jerry Greenfield evaluated the pros and cons of the corporate form of ownership, and the “pros” won. The primary motivator was the need to raise funds to build a $2 million manufacturing facility. Not only did Ben and Jerry decide to switch from a partnership to a corporation, but they also decided to sell shares of stock to the public (and thus become a public corporation). Their sale of stock to the public was a bit unusual: Ben and Jerry wanted the community to own the company, so instead of offering the stock to anyone interested in buying a share, they offered stock to residents of Vermont only. Ben believed that “business has a responsibility to give back to the community from which it draws its support”. He wanted the company to be owned by those who lined up in the gas station to buy cones. The stock was so popular that one in every hundred Vermont families bought stock in the company. Eventually, as the company continued to expand, the stock was sold on a national level.
- IRS. (2015). SOI Bulletin Historical Table 12: Number of Business Income Tax Returns, by Size of Business for Income Years 1990-2013. IRS.gov. Retrieved from: https://www.irs.gov/uac/soi-tax-stats-historical-table-12 ↵
- AllBusiness Editors. (2016). How Much Does it Cost to Incorporate? AllBusiness.com. Retrieved from: http://allbusiness.sfgate.com/legal/contracts-agreements-incorporation/2531-1.htm ↵
- Lager, F. C. (1994). Ben & Jerry’s: The Inside Scoop. New York: Crown Publishers. ↵
- Lager, F. C. (1994). Ben & Jerry’s: The Inside Scoop. New York: Crown Publishers. ↵