A sole proprietorship is a business arrangement where you and the business are the same entity, while a corporation is a business arrangement where the you and the business are separate entities. Let’s go into what this means.
A Sole Proprietorship
When you run a business without registering it as a corporation or partnership, you’re running a sole proprietorship, a business arrangement where you and the business are the same entity under the law. This means a couple of things.
- If the business makes a profit, that profit is considered your personal income
- If the business encounters legal issues, you encounter legal issues
Let’s go into an example and flesh out the implications.
Say, Cajetan Martin graduated from Le Cordon Bleu, is now a master baker and wants to open a bakery. If he goes to the Ontario website and registers his business as a sole proprietorship, he can open a business given the normal procedure of finding a location, getting the right licensing and the right equipment. If his business makes a profit, he has to declare that to the Canada Revenue Agency (CRA) as personal income and therefore pay income tax on on his profits. In other words, he has give some 30% of his profits immediately away personal income taxes!
Further, if someone gets sick from his shop because of a mistake from one of his employees and sues the shop, he is personally liable for the outcome. If the penalty is so steep it would bankrupt him, then he’d have to go bankrupt (of course, general liability insurance attempts to protect the business in these situations).
These implications do not exist for corporations. The only reason a sole proprietorship is so useful is because it’s very easy to start up.
Again, a sole proprietorship and its founder are seen as the same entity under the law. However, a corporation is a business entity that is legally separated from its founder. What does this mean for you?
- If the business makes a profit, that doesn’t mean you made any personal income
- If the business encounters any legal issues, that doesn’t mean you encounter any legal issues
Income Tax Implications of a Corporation
Say, Cajetan Martin decides to incorporate his business. In his first year, he generates a profit. When he declares that corporate profit to the CRA, he’ll only have to pay corporate tax which is around 15%. Now, Cajetan still has to pay his personal bills, so he’ll still need personal income. However, rather than taking all the remaining money from his business as income, he can take only what he needs for that year. If he doesn’t need much for the year, he gets to pay lower personal taxes.
Corporations also have tools called “shares”. In every corporation, there is a person or a group of people that run the corporation. These people get a share in the ownership of the business. Say Cajetan brings in his little sister and little brother, Therese and Michael Martin, into the business as his business partners. He can own 60% of the business and give 20% to each of his siblings. To give them something tangible to prove that they own part of the business, the business can issue “shares”, a representation of a part of the ownership of the business. If the business has 100 shares, Cajetan gives 20 to Therese and 20 to Michael and keeps the remaining. Why is this important?
- Shares allow you to exert influence in corporate decisions. Since Cajetan owns the most shares, he has the final say on what the company can and can’t do.
- If he wants to get extra financing for his business, he can sell a portion of his shares to someone else. That person gets ownership of the business and Cajetan gets the extra funding.
- Finally, if Cajetan needs some money personally, rather than taking it out as personal income (for which he’d have to pay taxes), he can get the corporation to pay dividends to all shareholders. Since he’s a shareholder (he holds 60 shares), he gets some income through dividends. Dividends are useful because taxes on that are lower as discussed by TurboTax.
Further, the corporation is a separate legal entity from you. If someone got sick from Cajetan’s shop, they’d sue the corporation, not Cajetan (unless the founder’s did something criminal). If there was a possibility that the bakery was at fault for the sickness, only the corporation would have to pay. Finally, if the penalty was so steep that it would bankrupt the business, only the corporation would go bankrupt. Like a sole proprietorship, there is general liability insurance that would buffer the company from too much of a hit.
Of course, as a good man, Cajetan would never allow this to happen in the first place, but it’s good to know that a corporation has this feature built into it.
Complications of a Corporation
With the number of benefits available to a corporation, it’s no wonder all of the big companies are corporate. At the same time, with the how complicated corporations are, it’s no wonder many of the small companies run a sole proprietorship. Some of the complicates include (among other things):
- Needing a lawyer to draft the Articles of Incorporation and Shareholder Agreement
- Needing an accountant to file your taxes
- Keeping a log of yearly shareholder meeting minutes
So, which should you choose? A sole proprietorship or a corporation?
All in all, that’s the major difference between a sole proprietorship and a corporation that I can see so far. I’d say that if your business is small and has little chance of being sued, start off as a sole proprietorship. Wet your feet in the world of business. Once you feel more confident, talk to an accountant about the tax benefits of creating a corporation. If the benefits are worth it and if you feel you have a good grasp of how to run a corporation, switch over to a corporation and continue running your business.
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