One of the most common questions that we hear from our clients at Collins Barrow is, "What type of structure is right for my business?"

The three most popular ways of structuring your business are:

• Proprietorships - whereby the business is operated by a single individual
• Partnerships - whereby two or more people operate the business
• Corporations - whereby the business is operated by a distinct legal entity

The following article outlines some of the primary advantages and disadvantages of each type of business structure.

Simplicity and administrative costs

Partnerships and proprietorships are simpler and less expensive to administer than corporations. Transactions are easy to understand and financial statements are not always required, therefore simplifying accounting and bookkeeping. Additionally, no separate tax return has to be prepared for the business as it is included as part of the personal tax return.

In the case of partnerships, legal advice may be required to register the partnership's name and prepare a partnership agreement. Depending on size, the partnership may also be required to file a partnership information return with the CRA. These requirements could increase the administrative costs for partnerships slightly over proprietorships.

For corporations, accounting and bookkeeping costs will be higher because of the added complexity of the corporation and the necessity to prepare financial statements along with separate corporate and personal tax returns. Additional legal costs will also be incurred to set up the corporation and prepare annual shareholders' resolutions. The owners of the corporation will also have to get used to more complicated concepts (i.e., dividends, preferred shares and shareholder loans).

Limited liability

With partnerships and proprietorships, all personal assets (not just the business assets) can be exposed to the creditors of the business. Additionally, in the case of partnerships, each partner is jointly and severally liable for the actions of the other partners. This means that even if only one of several partners is negligent, all of the partners will be exposed to the accompanying loss.

The corporation, because it is a separate legal entity, provides protection for personal assets from creditors. It is also possible to set up a separate holding corporation to provide additional protection. However, it should be noted that personal guarantees could be required for corporate debt that would offset some of this protection.

Canada Pension Plan

Like employees, proprietors and partners must make Canada Pension Plan (CPP) contributions on their business income. However, unlike employees, self-employed individuals must pay both the employer and employee share of the CPP premiums. Therefore, the self-employed maximum contribution in 2012 would be $4,614, compared to $2,307 for an employee.

However, even though the self-employed individual pays double what employees pay, the benefit they will receive from the CPP will be the same. For this reason, the CPP's return on investment for self-employed individuals is not favorable. This is especially true if the business owner dies prematurely as most or all of the CPP premiums paid over the years could be lost.

For corporations, CPP also has to be paid if salaries are paid from the corporation to shareholders. However, shareholders of the corporation also have the option of being paid with dividends instead of salaries. Since CPP contributions are not required on dividends, shareholders could instead invest the CPP premiums saved in an alternative investment account (such as an RRSP or TFSA) that could potentially provide a higher return than CPP for disciplined individuals. This option of being paid dividends to save CPP is not available to proprietorships and partnerships.

Deductibility of losses

For proprietorships and partnerships, any losses for tax purposes from the business can be deducted against other sources of personal income. For corporations, losses can only be used to offset business or property income within the corporation.

If losses are expected, it may be preferable to have a proprietorship or partnership over a corporation. However, it should be noted that the amount of proprietorship and partnership losses that can be deducted against personal income may be restricted or even denied entirely by the CRA if it can be established that there is no reasonable expectation of profit.

Tax deferral

Farm proprietorships and partnerships are exposed to progressively higher tax rates as taxable income increases. This means that profitable businesses could be paying income tax at rates approaching 50%, therefore limiting the amount of after-tax cash available to invest in the business. Even if business income is moderate, some one-time events (such as a land sale) could push income into one of the higher tax brackets. In these situations, farm proprietorships and partnerships are often scrambling to prepay expenses before the end of the year to limit their tax liability. This option is less than ideal as decisions are being made based on taxes and not what is actually good for the long-term profitability of the business.

Corporations, on the other hand, have a flat tax rate of only 15.5% up to $500,000 of taxable income. This low rate of tax means there is more money available in the business to pay off debt, invest in assets and meet working capital obligations compared to partnerships or proprietorships. This deferral also does not cease when shareholders retire. The shareholders can use the corporation as an investment retirement vehicle - similar to an RRSP.

As an example, let's assume the business has a $250,000 interest-free loan. Owner A is incorporated with a tax rate of 15.5%. Owner B is not incorporated and has a rate of 40%. Owner A would require $295,858 in profits to retire this loan at 15.5% tax. Owner B would require $416,667 on profits to retire the same loan. In other words, Owner A would be well on his or her way with their next asset acquisition before Owner B can handle another loan. The addition of interest would make the Owner A scenario even more attractive.

If should be noted that this deferral advantage would be lost if all the corporate profits were paid out to the shareholder. However, this is not a concern if the goal is to re-invest and grow the business.

It should also be noted that the deferral advantage for corporations increases as income increases. For businesses with lower incomes, there may be little to no tax deferral advantage at all.

Social benefits

Many government benefits, such as the personal HST credit, Employment Insurance (EI) maternity benefits, the Canada Child Tax Benefit, Old Age Security and Ontario Student Assistance Program (OSAP) are affected by the amount of income reported on the personal tax return. In the case of proprietorships and partnerships, all of the income generated from the business has to be reported on the personal tax return regardless of whether it is actually needed for living expenses and this could limit or eliminate these benefits.

In the case of EI maternity benefits, even if the associated partnership or proprietorship is in a loss position, these benefits could be affected. This is because gross business income (before deductions) is used as the basis to determine eligibility.

With a corporation, you can limit the amount of wages and dividends paid to the shareholders and, therefore, it is much easier to qualify for these benefits.

Workplace Safety and Insurance Board (WSIB)

To split income with your spouse or children in a proprietorship, you need to pay them a salary. This salary would not only be subject to tax withheld and CPP but it will also be subject to WSIB insurance premiums.

With a partnership, the partners do not have to pay WSIB on their income allocations. However, any wages to non-partners (such as the owners' children) would be subject to WSIB.

With corporations, it is possible to avoid WSIB on wages to children if they are made directors or officers of the company (as long as they are active in the business). These children do not have to be shareholders in the company to be appointed as directors or officers.

Capital gains exemption on farm property

There is a $750,000 capital gains exemption on the disposal of eligible farm property (i.e., such as land and quota).

It is easier to realize this gain with a proprietorship or partnership as individual assets can be sold outright and the exemption can be claimed. Each individual is entitled to this exemption so it is an advantage to have a partnership over proprietorships as the capital gain exemption would be multiplied (i.e., two partners would have $1.5 million in capital gains exemption, compared to only $750,000 with a proprietorship).

For corporations, it is more complicated to claim this exemption on individual property as compared to proprietorships and partnerships. This is because the corporation itself does not have a capital gain exemption - only the shares of the corporation qualify. Therefore, to claim the exemption on individual property, the asset must first be rolled into another corporation. This creates addition administrative costs and complexities that you would not have with a proprietorship or partnership. Many farm businesses have some real estate owned outside the corporation.

Asset transfers

Proprietorships are the only business structure that allows individual pieces of farm property (such as one piece of land) to be transferred to the next generation at less than fair market value.

For corporations and partnerships, only the partnership interest or the corporate shares can be transferred in this manner. This could be a concern, for example, if the farmer wanted to transfer two separate pieces of land at less than fair market value to two different children. For this reason, it sometimes makes sense for individuals to own land separately from the corporation.

Reasonableness test

Any salaries paid from proprietorships, partnerships or corporations must be reasonable for the work performed otherwise they could be denied by the CRA. Similarly, partnership income allocations must also be reasonable. However, having a partnership agreement that spells out clearly the responsibilities of each partner and how their income allocation is to be determined will help support the reasonableness of the income allocations.

With corporations, the reasonableness test only applies to salaries - not dividends. Therefore, you can pay anything you want to shareholders in dividends and not have to worry about whether the payment is reasonable for the work performed.

Non-calendar year-end

Corporations can choose a non-calendar year-end for tax purposes. The main advantage of this is to provide a window of time to plan in advance for personal taxes which are always based on the December 31 year-end. Another advantage is that the year-end can be chosen at a time when the business is not as busy and you have more time to attend to the year-end administrative work. There may also be a tax deferral opportunity with an off calendar year-end - especially for cash crop operations where cash flow is seasonal.

Proprietorships and partnerships cannot easily choose a non-calendar year-end without suffering adverse tax consequences. Therefore, this is not a viable option for them.

Dividend discretion and isolation of control from equity growth

With a corporation, it is possible to set up multiple classes of shares where dividends can be paid out to various family members (active and otherwise) in amounts that do not reflect the actual ownership percentage in the business. This makes it easier to split income among family members to minimize income tax as compared to the proprietorship and partnership.

With a corporation it is also possible to set up share structures where control rests with one set of shareholders while growth in the business accrues to another set. This feature is particularly useful in succession planning and is, again, not possible with proprietorships and partnerships.

Secondary wills

Under Ontario law, secondary wills can be set up to address the shares of private corporations. The advantage of doing so is that the assets of the corporation would not be subject to probate tax upon the death of the shareholder, which can be up to 1.5% of the value of the business.

It is not possible to set up a secondary will to deal with the business assets of proprietorships and partnerships. Therefore, the probate tax cannot be avoided.

Conclusion

This article outlines only some of the major advantages and disadvantages of each type of business structure. There are many additional complexities that cannot be addressed in a single article. Therefore, it is important to get professional advice to determine which business structure is right for you.

Thomas Blonde, BSc (Agr), CA, is a Partner in the Elora office of Collins Barrow.