Ask A Lawyer – “What is the difference between a sole proprietorship and an incorporated business? Should I incorporate my business?”

Whether or not you should incorporate your business or operate as a sole
proprietorship depends on a number of factors, including your financial situation, type of
business, and which stage of business growth you are in. Each form of business comes
with its own set of advantages and drawbacks. It is important to note, however, that
whether to incorporate or operate as a sole proprietorship is an ongoing consideration and
doesn’t need to be a final decision made early on – a sole proprietor has the option of
incorporating their operations at any point.

What is a sole proprietorship?
A sole proprietorship is a form of business where the business owner (the
“proprietor”) is carrying on their operations in their own name. Under this structure, there is
no legal difference between the business itself and the proprietor; they are one and the
same. As a result, there are no shareholders, no directors, and no officers. In other words,
the business and its activities are indistinguishable from the individual who is running the
operations – all employees are employed personally by the proprietor, all income is taxed
as belonging individually to the proprietor, and all assets and debts belong personally to
the proprietor.

What is a business corporation?
A business corporation is a distinct legal entity from its owners, resulting in a more
complex structure. A business corporation is owned by its shareholders, controlled by its
directors, and day to day operations managed by its officers. As a distinct legal entity,
employees are generally employed by the corporation and not the shareholders, any
income produced is taxed as corporate income, and any assets and debts belong to the
corporation.

What are the advantages and disadvantages of each?
A sole proprietorship is advantageous in that it is easy to start up and shut down –
an individual merely has to begin carrying on business. While a sole proprietor may register
a business name if they wish, there is no requirement to do so. Furthermore, unless the
sole proprietor registers a business name, there is no paperwork that needs to be filed to
maintain the sole proprietorship. This makes the sole proprietorship a popular method of
carrying on business, especially in the early stages of a business’s growth. In contrast, a
business corporation is more complex to set up from the outset, and annual forms must be
filed with corporate affairs to keep the corporation going.

However, there are several downfalls to the sole proprietorship, all of which may
become more acute as a business grows. First, the lack of a distinct legal entity from the
proprietor results in the proprietor being exposed to additional risk. For example, since the
business is not distinct from its owner, any lawsuit against the business, whether from a
customer or a former employee, is really a lawsuit against the owner. This would result in
their personal assets, such as their home, being at risk. This is in contrast to a corporation,
where generally speaking any lawsuit only places the assets of the corporation itself – and
not the assets of the shareholders – at risk.

Similar considerations apply to debts of the business. If operating as a sole
proprietorship, any debts incurred by the business are the responsibility of the proprietor
personally. This means that if payments are not made, creditors may pursue the personal
assets of the proprietor. In contrast, the shareholders of the corporation are generally not
personally responsible for any debt, unless they sign a personal guarantee to a creditor
which would make them responsible if the corporation defaults on its payments.
There are also some estate planning considerations that apply when deciding
between a sole proprietorship and a business corporation. If operating as a sole
proprietorship and the proprietor dies, the proprietorship is dissolved immediately upon
the death of the proprietor. This can result in negative financial consequences as all debts
must be repaid in full, generally from the assets of the estate. The consequences are
compounded as there will be no additional income from an operating business to help pay
any outstanding debts. This has the potential to produce a sudden heavy financial burden
upon the death of the proprietor. In contrast, a business corporation continues operating
despite the death of a shareholder, debts do not immediately become due, and the shares
become an asset of the estate of the deceased, meaning they can be left to a beneficiary of
the deceased’s choosing.

Finally, if operating as a sole proprietorship, any income generated by the business
is taxed in the hands of the proprietor personally in the taxation year it is earned, and may
be subject to higher tax rates given that corporate income tax rates are generally lower than
personal income tax rates. In contrast, income generated by a business corporation is
taxed at the corporate level, benefitting from lower corporate rates. This income may then
be distributed to shareholders by declaring a dividend on the shares, and any such
dividend payments are taxed individually in the hands of the shareholders. Alternatively, a
corporation may opt to not make dividend payments to shareholders, using it to reinvest
and grow the business, or leaving the income in the corporation until dividend payments
are made in a future tax year and resulting in a tax deferral for the shareholders.
Furthermore, if you opt to incorporate, you can add additional shareholders, such as your
spouse and children, who can then receive dividends from the corporation. This may ease
the tax burden on you personally while still ensuring the income earned from the business
still benefits you and your family.

If you are wondering which business structure is best for you, or if you wish to
discuss your options further, do not hesitate to contact Mosher Chedore at
info@mosherchedore.ca or 506-634-1600.