Starting a business can feel like entering a regulatory and tax jungle without a guide. There’s no doubt that Canadian business and tax laws can be complex, and the administrative burden for small business owners can be heavy, but once the initial major decisions are made, and the systems to comply with the administrative load are put in place, the prospect isn’t nearly as daunting as it first appears.
When is it business?
Small businesses can start as a hobby or leisure activity that grows and becomes more and more lucrative, until the line between hobby and business blurs. As well, in today’s economy of short-term contracts and part-time positions, it’s not unusual for individuals to hold down a job and run a small business “on the side”. Hence, the question often arises – when am I actually running a business, and what are my legal and tax obligations at that point?
Hobby or Business?
• How much time is spent on the activity?
• How much effort is put into selling the product created by the activity?
• Is there an intention to make a profit?
• Is a profit being made?
• Is the activity of a nature that would include an element of personal enjoyment?
The Canada Revenue Agency (CRA), defines a business as “an activity that you conduct for profit or with a reasonable expectation of profit”. Whether there exists a reasonable expectation of profit is something which can be determined only over a period of time, often years. Similarly, the intention of the person carrying out the activity can be assessed only from the conduct of the person and the nature of the activity being carried out. There are no hard and fast rules simply because each situation is different.
So let’s say you’re now a business owner—what’s the first step? The first and most important decision to be made is the legal structure your business will assume. You have essentially three choices: sole proprietorship, partnership, and corporation. There is no absolute right or wrong answer here. The “best” choice is the one that best meets the legal and tax needs of your particular business and personal situation.
The sole proprietorship can be the first choice of many new small businesses, and for good reason. It’s (relatively) simple and cheap to set up and run, and the regulatory and filing burdens can be much less than those imposed on incorporated businesses. The income and expenses of the sole proprietorship are summarized on a statement of business activities that forms part of the proprietor’s personal income tax return. Unlike a corporation, a sole proprietorship is not a legal entity separate from its owner. That means that the owner of the sole proprietorship takes on all risks, and those risks extend to the owner’s personal property, including his or her home. In other words, if the business owes money or has liabilities, creditors of the business can seek to have those debts satisfied by the assets of the business or by the personal property of the business owner.
Operating as a partnership
Where you have decided to go into business with others, you could usually choose between a partnership and a corporation as a business structure. If you choose to go into business in partnership with others, a written partnership agreement between the parties setting out their respective roles and responsibilities, and especially, the division of partnership revenue, is always advisable. Like a sole proprietorship, a partnership does not pay taxes itself and does not file an income tax return. Rather, the income and deductions of a partnership are calculated, and then each partner must include on his or her personal tax return, his or her share of the partnership’s income, or loss, for the year. The partnership business structure generally benefits from the same advantages and suffers the same disadvantages as the sole proprietorship. The time and effort involved in setting up the partnership and complying with ongoing administrative obligations, although greater than that required for a sole proprietorship, are not that onerous. However, as with the sole proprietorship, partners bear individual responsibility for the debts and obligations of the partnership, and in addition, are generally bound by the actions of their partners.
Incorporating a business
The corporation is the most sophisticated of the basic business structures, and not surprisingly, it is the most complex to set up and operate. Unlike the sole proprietorship and the partnership, a corporation is a separate legal entity. This separate legal existence means that, generally, shareholders of a corporation are not held personally responsible for the debts or liabilities of the corporation (with one important exception, outlined later).
Creating a corporation generally requires the services of a lawyer, as there are incorporating documents to be drafted and filed with the appropriate government authorities. It is also important to note that, if there is more than one shareholder in the corporation (where, for instance, you are starting a business with one or more other investors), it is advisable to enter into a unanimous shareholders’ agreement (USA). This agreement, much like a partnership agreement, sets out the respective rights and obligations of the company’s shareholders and indicates what will happen on the occurrence of certain events (i.e., the death of a shareholder or the withdrawal of a shareholder from the business). Once again, the drafting of a USA is usually done by a lawyer.
Once the corporation is established, it will have both corporate and tax filing obligations to meet. On the tax side, income earned by an incorporated business is income of the corporation, for which a corporate tax return must be filed, and on which corporate income tax must be paid at the applicable corporate income tax rates. Income earned by the corporation may then be paid out to its shareholders in the form of dividends, and to its employees in the form of salaries and/or bonuses. In all cases, the corporation must maintain a set of books recording the income and expenditures of the company.
On the administrative side, the corporation will be required to maintain annual filings (the specifics of which will vary depending on the jurisdiction in which the corporation was incorporated) in order to maintain its corporate status. Such filings are usually looked after by the company’s lawyer.
Generally, the biggest single advantage of the corporate structure over that of a sole proprietorship or partnership is that corporate shareholders enjoy “limited liability”, meaning that shareholders cannot be held liable for the debts or liabilities of the corporation. In effect, any corporate obligations or liabilities must be satisfied by corporate assets, and not by the personal assets of shareholders. However, financial institutions which are asked to provide financing to the corporation by means of a line of credit or a loan, frequently require that major corporate shareholders (especially in a small corporation), provide a personal guarantee. This means that the shareholder guarantees that any debts owed by the corporation to that financial institution will be paid by the shareholder personally if the corporation cannot make the required payments. The CRA also takes the position that this applies to taxes as well. Specifically, its Guide for Canadian Small Businesses provides that “If your corporation owes taxes, and you have personally guaranteed any loan on behalf of your corporation, we will claim the amount of the taxes owing up to the limit of the loan guarantee”.
There are numerous other business/tax issues like differing income tax rates, GST/HST, PST, WCB, payroll remittances, T4/T5 filings to report wages and dividends paid etc… that have are beyond the scope of this article. Please obtain professional advice with respect to these items from your accountant.
Also, the CRA issues a great number of publications and guides of help to small business owners. Virtually all those publications are available on the Agency’s website – http://www.cra-arc.gc.ca, which also contains much helpful information on a variety of topics of interest to small business owners. The Agency maintains a toll-free Business Enquiry Line (1-800-959-5525) at which you can speak to a CRA client services representative.
We also encourage you to contact one of our Partners at White Kennedy and schedule a consultation about your business, and the best way to move forward for you.
The information contained in this article is general in nature is not taxpayer specific. Before relying on any information in this article, please consult a professional to ensure the information you are relying upon is revelent in your particular situation. Tax law is subject to continual change, at times on a retroactive basis. Should the law or its interpretation change, our advice may be inappropriate. We are not responsible for updating our advice for changes in law or interpretation after the date hereof.