Looking at starting a business? In this article, we explore the comparative advantages of the business structures available to two or more persons in Alberta who wish to conduct and own a business together in Alberta. This will provide clarity on whether you should incorporate your business or enter a form partnership.
Corporations and Partnerships Generally
A corporation is a separate legal entity from its owners (shareholders) but it enjoys many of the rights of a natural person. The corporation acts on the decisions of its directors and officers which are elected by the shareholders. These roles are often filled by the same people.
Partnerships recognize a business relationship, not a separate legal entity. The three forms of partnerships – general partnerships, limited partnerships, and limited liability partnerships – mostly conform to similar principles. While partnerships are governed by Alberta’s Partnership Act, partners can set their own rules by entering into a partnership agreement. The main difference between the different forms of partnership is the exposure of its partners to liability, which is discussed below.
Liability as a Business Owner
Every business faces potential liability. Dissatisfied customers, lenders, employees, and other persons may bring a legal claim against a business. As a result, the exposure to liability of a new business can dwarf its potential earnings. If your business is exposed to significant liability, this factor may be your most important consideration when choosing your business structure.
A main advantage of incorporation is the limited liability status of its shareholders. As creditors are limited to recovering from the assets of the corporation, shareholders only stand to lose their investments in the business and not to their personal assets. If a business plans to incorporate specifically because it risks significant liability, it should do so sooner rather than later as debt or liability cannot be avoided by incorporating after a debt or liability arises.
Nonetheless, a corporation’s protection from personal liability is not absolute. For example, lenders and suppliers often require personal guarantees to deal with small or newly formed corporations. Shareholders who sign such guarantees allow these creditors to recover against their personal assets if the corporation fails to meet its obligations. Other laws, such as tax, criminal, and environmental laws may also result in personal liability to the directors or officers of the corporation.
- General Partnerships
Under a general partnership, all partners can act for the partnership and each partner is personally responsible for all debts and liabilities of the business. Even if a partner fails to meet an obligation they wrongfully incurred in complete secrecy, the wronged party could seek to recover all of their losses from the personal assets of any partner.
General partners can avoid such personal liability by holding their partnership interest through a corporation. At the cost of increased expense and complexity, this hybrid arrangement allows business owners to enjoy the benefits of a partnership while protecting their personal assets.
- Limited Partnership
A limited partnership splits its partners into two categories: general and limited partners. A general partner is ultimately responsible for all partnership debts and liabilities of the partnership but makes all the decisions of the limited partnership. Limited partners act exclusively as investors in exchange for reduced liability. Creditors can still seek recovery from any limited partner, but only to the extent of that limited partner’s investment. As with a general partnership, general partners and limited partners can be corporations to avoid personal liability of the ultimate owners.
Further, limited partnerships help protect general partners by reducing who may act on behalf of the partnership. Only the general partner may make decisions for the limited partnership. As such, the limited partners are essentially “silent partners” which cannot bind the limited partnership to new debts or liabilities. If they try to act on behalf of the limited partnership, they may lose their limited liability.
- Limited Liability Partnership
Limited liability partnerships are reserved for licenced professionals such as lawyers, engineers, and accountants who cannot use a regular corporation to avoid liability for professional mistakes. This structure allows these professionals to work together by only holding them responsible for their own–as opposed to their partners–professional negligence or wrongful actions. Partners not involved in the wrongdoing do not bear any responsibility for the actions of their partners. For all other debts and liabilities of the partnership, limited liability partners are liable as if they were in a general partnership.
The choice of business structure determines tax obligations. When a business expects to lose money, such as in its early life or in a weak economy, a partnership can provide significant advantages. Conversely, incorporation offers tax advantages when the business is profitable. If tax is your primary concern for your new business, it may be advantageous to begin as some form of partnership and then incorporate at a later date.
Partnerships do not pay income tax. Instead, the individual partners are personally taxed on their income from the partnership. This allows the partners to offset losses of the partnership against their future tax obligations or other streams of income. These tax savings can be pocketed or put back into the business. A corporation can only offset its losses against its own profits, so tax savings are trapped in the corporation if it does not become profitable later on.
Partners can also deduct business expenses from their personal tax returns, unlike the shareholders of a corporation. This advantage is usually most beneficial at the start of a business when significant start-up costs may be required.
Please consider that the tax advantages of partnerships may not apply equally to limited partnerships, which are subject to specialized tax rules. For example, limited partners can generally only offset losses to the extent of their investment. Given these special rules, limited partners should seek professional tax advice on an ongoing basis.
A corporation’s primary tax benefit is access to lower tax rates. Alberta has a comparatively low corporate income tax rate and corporations are subject to a further reduced tax rate on their first $500,000.00 earned each year through the small business deduction. These savings provide corporations with increased access to opportunities.
It is important to note that these reduced tax rates only defer taxes. For any corporate earnings paid out as dividends, the recipient shareholders will pay any difference between the corporate income tax rate and their personal income tax rate. Accordingly, business owners seeking to take advantage of reduced corporate tax rates for the growth of their business must have the financial flexibility to leave money within the corporation.
A shareholder who is able to leave money in the corporation for re-investment is also potentially creating personal tax savings. For example, a shareholder could leave their funds in a corporation until they fall from a high to a lower income tax bracket, such as upon retirement. By delaying receipt of funds, that shareholder may pay less taxes.
Corporations allow for another tax strategy involving tax brackets such as income-splitting within a group of shareholders who are part of the same family. There are special and complex rules to comply to achieve this in Canada which are known as the “TOSI rules”. Advice from a tax accountant on these rules is a must when considering this strategy.
Shareholders of a corporation may enjoy more tax advantages as they can receive money in several forms including salaries, bonuses, dividends and capital gains which may provide better tax results than just receiving a salary.
Canada’s Lifetime Capital Gains Exemption may confer a further tax advantage to shareholders upon the sale of qualifying shares. A business owner selling qualifying shares in a corporation could be eligible for up to $913,630.00 in capital gains exemptions in 2022.
Costs and Administration
Partnerships are relatively inexpensive to form and maintain. Even limited partnerships, which may require ongoing professional advice to navigate specialized tax rules and roles of partners, are typically less expensive to operate than a corporation.
General partnerships are only required to register their business when they plan to operate under a trade name rather than the names of their partners. All limited partnerships and limited liability partnerships must register their business by providing certain information, and they must keep those registrations up to date. Despite these requirements, the costs are minimal.
Typically, the main start-up cost for partnerships will be preparing a partnership agreement. A partnership agreement sets the terms of internal governance. While partnership agreements are only legally required for limited partnerships, all forms of partnerships should have one in place to prevent future issues. Partnerships without an agreement, for example, must distribute all profits equally (regardless of contribution) and immediately dissolve upon the exit of any partner (regardless of reason).
The ability to impose a partnership agreement makes partnerships favourable over corporations from an administrative standpoint. As partnerships can set their internal governance procedures, they can effectively choose the extent of how they will be administered and by whom. This is also beneficial when it comes to moving funds out of the business, as a partnership agreement provides an easy method to set up specific compensation schemes.
The start-up cost for a corporation may be more than a partnership. Corporations are also subject to significant ongoing administrative expenses as the corporation is its own legal entity and thus a taxpayer. Annual filings are required to maintain a corporation. Any internal change, such as a change in ownership or management, requires legal documentation and additional filings. Also, taking advantage of a corporation’s potential tax advantages will require consultations with a tax accountant for best results.
Internal Duties and Liability
While shareholders enjoy limited liability, shareholders who also act as directors can face personal liability for their actions or for failing to meet duties owed to the corporation. The duties of directors include the duty to act in good faith and in the corporation’s best interest, even where such interests conflict with their personal interest. Directors must also act with a reasonable degree of competence. A director who honestly fails to meet these duties may, however, have certain defences available.
Directors can also face personal liability by failing to comply with certain statutory obligations, such as failure to pay employee wages, remit taxes, or comply with environmental obligations. Directors may or may not be able to recoup such losses from the corporation.
General partners must meet duties similar to those of directors. Partnerships can also impose internal liability in their partnership agreements. In the absence of a partnership agreement, general partners must comply with the default provisions of the Partnership Act. Limited partnerships are subject to additional obligations, such as keeping limited partners informed and obtaining the consent of all limited partners before acting contrary to the terms of the partnership agreement or admitting new general partners.
Protections for Shareholders and Partners
A general or limited partner’s protection from the actions of its other partners is largely dependent upon the terms of the partnership agreement. Partners have limited recourse against the partnership unless they can rely on a term of their partnership agreement.
Corporations provide enhanced remedies to shareholders, who can access statutory causes of action such as “oppression actions” and “derivative actions”. Oppression actions provide prejudiced shareholders with broad remedies while derivative actions may allow shareholders to bring legal actions on the corporation’s behalf.
Access to Capital
For several reasons, corporations generally have greater access to external financing and enjoy favourable interest rates. As loan repayments are made on an after-tax basis, Alberta’s low corporate tax rate effectively means corporations require less revenue to repay loans. Lenders can also establish priority over other business creditors by using guarantees. Finally, corporations help ensure funds are used responsibly as they are not available to shareholders for personal use.
In terms of internal financing, corporations and partnerships with thorough partnership agreements can flexibly allow owners to invest in their business.
Limited partnerships are advantageous for partnerships seeking financing as investors can be recruited as limited partners without altering the management of the business. As general partners are bringing on investors as opposed to colleagues, they can afford to accept investments from a wider pool of people.
Less extensive reporting requirements for partnerships provide a privacy advantage over corporations. Corporations must publish updated lists of all names, address, shareholdings, and offices held for those involved in the business. Most general partnerships are not subject to any form of disclosure requirement. While limited partnerships are required to provide contact information of each general partner, they are not required to provide any such information for limited partners.
An advantage of general partnerships over other forms of business structures is that they can operate across provincial borders without taking further action, except where that partnership operates under a business trade name other than the name of its partners. General partnerships conducting business under a trade name such as limited partnerships and limited liability partnerships must register in each province where they conduct business. Corporations can only operate in the provinces in which they are registered.
The cost and difficulty of registration in additional provinces varies depending on the province involved. For example, an Alberta corporation can register in British Columbia or Saskatchewan at no charge under the New West Partnership Trade Agreement but registering in Ontario will cost at least $300. As discussed in the next section, provincial corporations face the added issue of whether their name will be available.
An Alberta corporation has the exclusive right to use its registered name within the province. The corporation may also take legal action to stop others in Alberta from using names which are confusingly similar to its own. An Alberta corporation can extend such protections provincially through registrations or across Canada through federal incorporation. For this reason, business owners looking to expand across provincial borders should consider incorporating federally.
Partnerships lack any form of automatic name protection. A partnership which registers its name does not have ownership of that name, meaning future partnerships or corporations can later register the exact same trade name. Registration only acts as proof that the partnership operates under the provided trade name.
Both partnerships and corporations can apply to register a trademark, which prevents commercial use of confusingly similar names throughout Canada and offers enhanced enforcement rights. However, the expense and time involved in obtaining a trademark often means this is only a viable option to larger businesses.
Residency Requirements of Corporations
Alberta corporations no longer require a proportion of directors of a corporation to be Canadian residents. The impact of residency on choice of business structure is now based on other considerations, such as differences in tax treatment.
If you would like to discuss how Alberta Corporations versus Forms of Partnerships may apply to your business, please contact Duncan Craig LLP Business Solutions Group.
Our Business Solutions Group handles the complete legal needs of Edmonton’s business owners at all stages of their businesses’ existence across the diverse range of sectors that make up the Alberta economy. When business owners choose Duncan Craig LLP lawyers, they are accessing a team capable of handling all the legal issues involved with running a business including commercial real estate, intellectual property, employment law, trademarks, banking, finance, and dispute resolution. Our estate planning capabilities allow us to ensure each business is structured in a manner that will minimize the business’s and owner’s personal tax obligations.
Over the decades, through boom and busts, our clients have always known that the lawyers at Duncan Craig LLP will do all they can to support and help their business. Being entrusted to help business owners pursue their goals and having the opportunity to work alongside them is a privilege our lawyers do not take for granted. We strive to be as committed to our clients as they are to their businesses.
Authors: Jeff Fixsen and Ryan Shearer (January 27, 2023)