Business Structure: Overview, Pros, Cons & How It Works

Defining the business structure at the start is key. Decisions made at the beginning of a new business might have big implications for the business down the track. This article will break down the pros and cons and how each structure works.

What is a Business Structure?

A business structure is the legal organization of a company that determines how it operates, raises capital, and manages its obligations. The chosen legal structure affects many aspects of the business, including liability, taxes, and the ability to attract investors. Business owners must consider their needs and goals when choosing a legal structure, as it can impact the growth potential, financial health and asset protection of the business. The right legal structure will provide a solid foundation for the business to meet regulatory requirements and operate efficiently.

Types of Business Structures

There are several business structures, each with its own features and benefits to suit different business needs. The most common business structures are:

• Sole Proprietorship: A simple and popular structure where the business is owned and managed by one person, with no distinction between the owner and the business.
• Partnership: A structure where two or more individuals share ownership, responsibilities, and profits according to a partnership agreement.
• Corporation: A more complex structure that offers limited liability, perpetual existence, and the ability to raise capital through stock issuance.

All of these have pros and cons. When starting a business, business owners need to consider their own needs and goals.

Sole Proprietorship

A sole proprietorship is the simplest and most common way to start a business. It is a business that is not incorporated and managed by one person. There is no separation between the owner and the business. The owner gets all the profits and is responsible for all the debts, losses and liabilities. This is easy to set up and run. The owner has complete control over all decisions and can run the business as they want. The downside is the owner’s personal assets are at risk if the business incurs debt or legal issues.

From a legal standpoint, a sole proprietorship is not considered a separate entity. This means the law and regulatory bodies see the business and the owner as one entity. So the owner has to report business income and losses on their personal tax returns and is personally liable for any business obligations. Although this simplifies tax filing, it requires careful management to protect the owner’s assets. This is recommended for small businesses or individuals testing a business idea before formalizing their business into a more complex structure.

Benefits of Sole Proprietorship

A sole proprietorship business structure has several advantages, which makes it a popular choice for individual entrepreneurs and small business owners. Here are some of them:

1. Simplicity and Ease of Formation: Setting up a sole proprietorship is straightforward, with minimal paperwork and legal formalities. In many jurisdictions, it requires only the registration of a business name and the acquisition of the necessary licenses or permits to start operating. This simplicity makes it an accessible option for many entrepreneurs.
2. Complete Control: The sole proprietor controls the business decisions and operations. This autonomy allows the owner to make quick decisions, adapt to changes, and manage the business according to their vision without consulting partners or shareholders.
3. Direct Benefit from Profits: The owner enjoys all the business’s profits without sharing them. This direct reward for the owner’s efforts and investment can be highly motivating.
4. Tax Advantages: In many jurisdictions, the business is not taxed separately. Instead, the owner includes the business’s profits or losses on their personal tax return. This can simplify the tax filing process and often results in lower taxes than those incurred by other business structures, such as corporations, due to the ability to directly deduct business losses from personal income.
5. Privacy: As the sole proprietorship is not a corporation, it generally requires less public disclosure of financial information. This privacy can benefit small businesses that prefer not to disclose financial details.
6. Flexibility: The sole proprietorship offers operational flexibility, allowing the owner to adjust business practices, pricing, and strategy without needing approvals from partners or a board of directors. This can be particularly beneficial in rapidly changing markets.

Disadvantages of Sole Proprietorship

While sole proprietorship has advantages, it also has disadvantages that an entrepreneur should consider before choosing this business structure. Here are some of them:

1. Unlimited Personal Liability: One of the most significant drawbacks of a sole proprietorship is that the owner is personally responsible for all the business’s debts and liabilities. This means that if the business incurs debt or faces legal action, the owner’s personal assets (like their home, car, and savings) are at risk of being used to settle business debts.
2. Difficulty in Raising Capital: Sole proprietors may find it challenging to raise funds since they cannot issue stock, and lenders may be hesitant to provide financing due to the perceived risk of single ownership. This limitation can hinder business growth and expansion efforts, as the owner often relies on personal funds or loans to finance the business.
3. Limited Life of the Business: The existence of a sole proprietorship is closely tied to the owner. If the owner decides to cease business operations, passes away, or becomes incapacitated, the business does not continue unless specific arrangements are made. This contrasts with corporations, which can exist perpetually beyond their founders’ involvement.
4. Burden of All Responsibilities: The sole proprietor is responsible for every aspect of the business, from daily operations to strategic decisions. This can be overwhelming and may limit the business’s growth potential, as one individual may not possess all the necessary skills or have enough time to effectively address every area.
5. Taxation at Personal Income Rates: While taxing on personal income can be advantageous during the early stages, or when the business incurs losses, it can become a disadvantage when it becomes highly profitable. In such cases, the owner may face higher tax rates than if the business were incorporated, where there could be more favourable corporate tax rates and tax planning opportunities.
6. Professional Perception: Sole proprietorships may be perceived as less professional or less credible than incorporated businesses. This perception can impact the business owner’s ability to attract clients, especially large corporations or government agencies that may prefer to deal with incorporated entities.

Partnerships

A partnership is a business structure where two or more people manage and operate a business according to the terms and conditions set out in a partnership agreement. Partners share profits and losses according to their ownership or as per the partnership agreement. Partnerships have more resources for the business in terms of skills, knowledge and financing than a sole proprietorship. There are different types of partnerships, including general partnerships, where all partners share in the management and liability of the business; limited partnerships, which have at least one general partner with unlimited liability and one or more limited partners with liability proportional to their investment; and limited liability partnerships (LLP), which provide some partners with protection from the liabilities of the partnership.

Partnerships are governed by provincial or territorial laws in Canada and are more flexible than corporations. Unlike corporations, partnerships are not separate legal entities from their owners. This means partners are personally liable for the debts and obligations of the business and can put their personal assets at risk. However, partnerships don’t pay income tax as a separate entity. Instead, each partner includes their share of the partnership income or loss on their personal tax return, which can be tax advantageous depending on the individual’s situation.

It’s important for potential partners to draft their Partnership Agreement to outline the operational, financial and profit distribution terms and other important details to avoid conflicts and to run the business smoothly.

Benefits of Partnerships

Here are some key benefits of operating a business as a partnership:

1. Shared Responsibility: In a partnership, the responsibility for the business, including decision-making and financial investment, is shared among the partners. This can lighten the individual burden and allow for a division of tasks according to each partner’s strengths and expertise. Shared responsibility enables more comprehensive decision-making and problem-solving as different perspectives and skills are discussed.
2. Ease of Formation and Flexibility: Similar to sole proprietorships, partnerships are relatively easy and inexpensive to establish, with fewer formalities and legal requirements than corporations. The flexibility in managing the business is also a significant advantage, as partners can quickly adapt to changes and make decisions without extensive bureaucratic processes.
3. Enhanced Capital and Resources: Partnerships often have a greater capacity for raising funds than sole proprietorships because they can pool the resources of multiple partners. This can lead to more significant investment in the business, better credit facilities, and the ability to undertake larger projects or expand more rapidly.
4. Tax Advantages: Partnerships are not subject to income tax; profits and losses are passed through to the individual partners, who then report this income on their personal tax returns. This can result in tax efficiencies, including the potential for income splitting (where allowable), which can reduce the overall tax burden.
5. Diverse Skill Sets and Networks: By bringing together partners with complementary skills, experiences, and professional networks, partnerships can leverage a broader range of capabilities and contacts. This diversity can enhance the business’s operational effectiveness, innovation capacity, and market reach.
6. Motivation and Support: Partners’ shared commitment can be a strong motivational factor, with each partner invested in the business’s success. Moreover, partners can offer mutual support, advice, and encouragement, which can be particularly valuable in challenging times.

Disadvantages of Partnerships

While offering numerous benefits, partnerships also present several disadvantages that should be considered. Some of the drawbacks include:

1. Joint and Several Liability: In general partnerships, each partner is individually and collectively responsible for the partnership’s liabilities and debts. This means that if the partnership cannot fulfill its financial obligations, the partners’ personal assets can be used to settle debts, potentially leading to significant personal financial risk.
2. Disputes and Conflicts: With multiple individuals having input into the business’s direction and decisions, there is an increased risk of disagreements and conflicts among partners. If not effectively managed, such disputes can impair decision-making, harm the business’s operational efficiency, and even lead to the dissolution of the partnership.
3. Shared Profits: While sharing the workload and responsibilities is an advantage, it also means that profits must be shared among the partners according to the agreement. This can be seen as a disadvantage if partners feel the distribution of profits does not accurately reflect their contribution or investment in the business.
4. Decision-Making Delays: The need for consensus or agreement among partners can sometimes delay decision-making processes, especially in partnerships where all partners have an equal say. This can hinder the business’s ability to respond quickly to market changes or opportunities.
5. Difficulty in Withdrawing: Exiting a partnership can be more complex than leaving a sole proprietorship. The withdrawal terms, such as the valuation of the partner’s share, must be agreed upon by all partners or as stipulated in the partnership agreement. This can lead to complications and potential conflicts if not clearly defined.
6. Limited Life of the Business: Similar to sole proprietorships, partnerships can be less stable over the long term since they may be dissolved upon the death, withdrawal, or bankruptcy of a partner unless there are provisions in the partnership agreement for such events.
7. Taxation Considerations: While pass-through taxation can be an advantage, it also means that partners are taxed on their share of the partnership income, regardless of whether or not this income is distributed. This can create financial strain if the business retains earnings for operational needs or expansion.

Incorporation

Incorporation is another option you might want to consider while starting a new business, regardless of whether you’re starting a business alone or with others. A corporation is a distinct legal entity (a legal person) that possesses all the rights and privileges of a natural person, such as owning property, borrowing money and entering into binding contracts. A corporation has directors and shareholders and legal responsibilities to maintain incorporation documents filed and up to date.

In addition, incorporating your business can have certain advantages, such as limited liability protection, tax benefits, and credibility. A corporation does not necessarily end with the death of its owner, as in a sole proprietorship. However, if you wish your business to continue to exist, you might have to do some planning with your family or employees or even create a will. If there is more than one shareholder in your corporation, you might want to consider having a shareholder’s agreement to plan for the transition.

Benefits of Incorporation

Incorporation offers a range of benefits that can be attractive for businesses looking to expand, protect their owners’ personal assets, or simply establish a more professional presence in the market. Here are some key advantages associated with incorporating a business:

1. Limited Liability: One of the primary benefits of incorporation is the limited liability protection it offers its owners (shareholders). In business failure or lawsuits, the shareholder’s personal assets are generally protected from creditors and legal actions. Only the assets owned by the corporation are at risk, which provides a significant layer of financial security to business owners.
2. Perpetual Existence: Corporations enjoy perpetual existence, meaning they continue to exist even if the ownership or management changes. This stability and continuity can be advantageous for long-term business planning and operations, making attracting investment and strategic partnerships easier.
3. Enhanced Credibility: Incorporation can enhance a business’s perceived credibility among customers, suppliers, and financial institutions. This can lead to better business opportunities, easier access to capital, and improved terms with suppliers.
4. Tax Benefits and Incentives: Incorporating a business may provide tax advantages unavailable to sole proprietorships or partnerships. For instance, corporations often benefit from lower tax rates on retained earnings, which can be reinvested in the business. Additionally, corporations may qualify for various tax deductions, credits, and incentives that can reduce the overall tax burden.
5. Easier Access to Capital: Corporations have more options for raising funds. They can issue stocks or bonds, which can be an attractive option for investors. This ease of raising capital can be crucial for expansion, research and development, and enhancing the company’s operations.
6. Ownership Transferability: Shares of a corporation can be bought, sold, or transferred without affecting the company’s operations or legal standing. This transferability of ownership can facilitate investment and allow for more straightforward succession planning.
7. Separate Legal Entity: A corporation is a separate legal entity from its owners. This separation means that the corporation can enter into contracts, own property, sue, and be sued in its own name, providing a clear distinction between the personal dealings of its shareholders and the business operations.

Disadvantages of Incorporation

Incorporation, despite its numerous benefits, also brings with it several disadvantages that businesses must consider before deciding to incorporate. Here are some of the main disadvantages associated with incorporation:

1. Complexity and Cost: The process of incorporation can be complex and costly. It involves significant paperwork, legal requirements, and regulatory compliance that can be daunting for small business owners. Additionally, ongoing costs are associated with maintaining corporate status, including annual filing fees, legal and accounting services, and other administrative expenses.
2. Regulatory Scrutiny and Compliance: Corporations are subject to more stringent regulatory oversight and compliance requirements than other business structures. These include maintaining detailed records, submitting annual reports, and adhering to corporate governance standards. Compliance with these regulations can be time-consuming and requires the expertise of legal and accounting professionals.
3. Potential for Double Taxation: One of the most cited disadvantages of incorporation is the potential for double taxation. This occurs when the corporation pays taxes on its profits, and then shareholders also pay taxes on any dividends they receive. However, this can sometimes be mitigated through tax planning strategies or choosing a corporate structure allowing pass-through taxation.
4. Impersonality and Rigidity: The corporate structure can introduce impersonality and rigidity into business operations. Decision-making can be slower due to the need for board approval and adherence to corporate policies, which might limit the company’s ability to be agile and responsive to market changes.
5. Ownership and Control Issues: In a corporation that issues stock to the public, the original owners may find their control over the company diluted as more shareholders join. Significant shareholders might seek to influence business decisions or pursue their own interests, which could lead to conflicts within the organization.
6. Complicated Tax Filing and Accounting: Corporations face more complex tax filing requirements and accounting practices than sole proprietorships or partnerships. This complexity often necessitates hiring specialized accounting professionals, which adds to operational costs.
7. Difficulties in Personal Benefit: In small corporations, separating personal and business expenses can be challenging and might lead to scrutiny by tax authorities. Business owners who are used to the flexibility of drawing from their business accounts as needed may find this separation restrictive.

Summary

Finding the business structure tailored to your needs requires a detailed planning process. It involves evaluating the benefits of different business structures and determining which offers the most benefits and advantages that align with your business goals, needs and future projections.

How We Can Help

Insight Law Professional Corporation is a corporate law firm. Whether you’re just starting out, looking to expand, or facing legal challenges, our team is here to provide the strategic advice and legal solutions you need. If you need guidance from a Toronto corporate lawyer, contact us and see how our firm can help.

The information provided above is of a general nature and should not be considered legal advice. Every transaction or circumstance is unique, and obtaining specific legal advice is necessary to address your particular requirements. Therefore, if you have any legal questions, it is recommended that you consult with a lawyer.