Profit and Policy: Starting with the Right Structure

All references to a spouse include common-law partners. All references to the ‘Act’ or the 'ITA' mean the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. All references to the ‘Regulations’ mean the Income Tax Regulations. The following should not be construed as legal nor tax advice. Consultation with your usual tax/legal professional is advised. Please contact us to discuss the contents of the article herein.

Good morning Toronto! Starting a business is exciting! One of the first decisions that the owner-manager will make is choosing the right ownership structure. Today's article will discuss some of the most common ownership structures and their applicable tax treatment.

Sole Proprietorships (SPs) are the simplest forms of business in Canada. Under this structure, the proprietor and business are considered 'one and the same.' Proprietors conduct business in their personal capacity, meaning that all liabilities incurred by the business are the sole responsibility of the owner. SPs are also treated as a Flow-Through Entity (FTE) for tax purposes – all net income earned by the business flows through and is considered taxable income on the proprietor's personal tax return. All SP income is reported on the proprietor's T1 Personal tax return using Form T2125: Statement of Business or Professional Activities.

In all businesses, it is common for owners to retain some profits to grow the company, after taking a salary. In SPs, unlike corporations (explained below), all profits - revenue, less any expenses - are fully taxable.** In other words, there is no opportunity to create tax savings by retaining money in the business. Furthermore, in the first years of the business, it is common for expenses to exceed revenue, creating a net loss. This net loss can be deducted against other sources of the owner's income, such as other employment. Net losses from a business are considered a 'non-capital loss' and can be carried forward for up to 20 tax years, by claiming it on Line 25200 of the T1 Personal return, or carried back 3 tax years, by submitting Form T1A: Request for Loss Carryback.*

*Form T1A must be submitted to the local tax centre. It CANNOT be submitted by NETFILE/eFILE.

**See Example 5 for a comparison to a corporation.

Like SPs, partnerships are considered 'one and the same' with their owners. However, the key difference is that a partnership involves two or more individuals who agree to carry on business together. For tax purposes, partnerships are FTEs. In proportion to their share of the business, each partner reports their share of the partnership's net income (or loss) on their T1 Personal return by attaching Form T5013: Statement of Partnership Income. Partnerships also follow the same net loss rules as SPs. Losses can be applied against other sources of the partner's income, with similar carry-forward and carry-back rules to SPs, as discussed above.

In Ontario, there are three types of partnerships.

• General Partnerships: Partners are 'jointly and severally' liable for the debts of the business. The personal assets of ANY partner can be pursued to settle partnership debts. In addition, a partner can be held personally liable for the malpractice or negligence of another partner, even if that partner was not aware or had any involvement in the transgression(s).
• Limited Partnerships: Composed of general and limited partners. The general partner manages the day-to-day business and, like a general partnership, has unlimited liability for all debts. The limited partner contributes capital, sharing the profits, but their liability is solely limited to the amount they invested. Generally, limited partners do not have active management roles – if they do, they may risk losing their limited liability protection.
• Limited Liability Partnership: Each partner is shielded from personal liability for the negligence or malpractice of other partners. However, they still remain personally responsible for their own actions. In Ontario, only lawyers, paralegals, and accountants can have an LLP.

Finally, there are corporations. Under the law, corporations are considered to be separate legal entities. This means that they are taxed separately, can file lawsuits, and can be sued in their own right. Corporations are not considered FTEs, and are taxed separately from their owners. The owner(s)' financial risk is generally limited to the amount of their investment. Creditors usually cannot pursue personal assets to cover corporate debts. However, if the owner personally guaranteed their personal asset(s) to secure loans for the corporation, then the creditor has recourse to seize the assets in the event of nonpayment.

Unlike individuals, who only pay provincial tax to the province they are ordinarily resident in on 31 December of the taxation year, corporations can be liable for provincial tax in each province/territory they have operations in. For example, if a corporation owned rental property in both Ontario and British Columbia, it would pay provincial taxes on the portion of income that was earned in each province, in addition to paying federal taxes.

Furthermore, corporations are taxed separately from their owners. They use the T2 Corporate return and enjoy income tax rates that are generally lower than those paid by individuals. Most Canadian residents that incorporate will meet the requirement of a Canadian-Controlled Private Corporation (CCPC). A CCPC is defined in ITA §125(7) as a corporation that is:

• Incorporated AND resident in Canada, AND
• Controlled by resident Canadians (in this context, ‘control’ means to own more than half the voting shares), AND
• NOT controlled by a public company (companies whos shares are publicly tradable on a stock exchange)

CCPCs can benefit from the Small Business Deduction (SBD), which greatly reduces the federal tax rates on the first $500k of active business income. To be considered active business income, the income must be earned from regular operations of the business. Passive income (income earned from other assets, such as capital gains and interest income) will phase out (lower) the SBD if over $50k. Generally, provinces have a lower rate on income that qualifies for the SBD, and a higher rate for income thereafter. For example, a CCPC that has all of its business operations in Ontario enjoys a combined 12.2% income tax rate (9% federal + 3.2% provincial) on the first $500k of active business income.

Another key feature of corporations is that owner-managers can pay themselves a salary.* Salaries are deductible from the corporation's income and then reported as employment income on the owner's T1 Personal return. This shifts the tax burden from the corporation to the owner, and also creates RRSP room and CPP pensionable earnings for the latter. However, unlike SPs and partnerships, corporations are not required to distribute all net income. Any earnings not paid out remain within the corporation as retained earnings, taxable at the applicable corporate rate.

*Owners generally have a choice between paying dividends or a salary - this option is to be explored in a future article.

At the end of the day, the choice of business structure is merely organizational. While it determines how income is taxed and how liability is accordingly allocated, it has no bearing on operational abilities. Regardless of structure, the owner-manager must still fully comply with all of the other requirements of running a business - such as complying with laws, remitting HST/GST (where applicable), and securing all relevant licenses/permits.

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Too complicated? No worries! KLee Tax specializes in filing tax returns and tax advisory for individuals, businesses, and corporations. Whether you are working your first job, running a business, or an NPO looking to make a difference, you can be sure that KLee Tax will be there for your tax needs, when and where you need us.

Contact us below for a consultation or to discuss the contents of this article!