©2005 A. Paul Mahaffy. All Rights Reserved.

Introduction

In setting up a business, one of the more important decisions to be made at the outset is what particular legal form will be used to carry on the business. While many businesses may be established as a corporation right at the beginning, a corporation may not be the best vehicle to choose. There are a number of alternative vehicles, and choosing which one to use can depend upon a number of considerations.

How many owners the business will have, how risky the business may become, how separate the owners will be from those managing the business, how the business will be financed, and how quickly the owners might want to sell out, are just a few of the questions that should be asked at the start - and that's before the potential of the vehicle to reduce or defer tax payable is even addressed.

Furthermore, the vehicle that is chosen at start-up may have to be changed as the business evolves, so that the ease of changing the original vehicle into another preferred vehicle later on can be a relevant consideration at the outset.

Although the sole proprietorship, partnership and corporation have traditionally been regarded as the main alternative vehicles which owners may choose when starting a business, a co-ownership arrangement or trust may be preferable instead. Some of these vehicles, particularly the partnership and corporation, are available in more than one form, thereby expanding the number of alternatives to choose from.

This paper will focus on the commercial features and advantages of various alternative business vehicles created under the laws of Ontario as well as corporations incorporated under the Canada Business Corporations Act.¹ It will not address those vehicles created under the laws of other jurisdictions which carry on business in Ontario except for unlimited liability companies incorporated under the laws of Nova Scotia and Alberta or local branches established by foreign corporations. Nor will it address non-profit corporations (even though they may generate a profit and may actually compete against business corporations) or corporations which are governed by special statutes, such as banks, insurance companies, co-operatives, or trust and loan companies.

This paper will also not address "joint ventures" as a separate category of business vehicle. Although the terms co-ownership and joint venture are sometimes used interchangeably, joint ventures can be partnerships or corporations instead. A joint venture is often the generic description of a business association requiring the participants to contribute certain services and resources for mutual gain and letting them participate in decision-making while retaining their own individual identities. The "pooling" of assets and sharing of equity in the venture are often what separate a joint venture from other strategic alliances or cooperative arrangements.

However, the legal status of a joint venture is difficult to define, since it usually uses one of the more traditional forms of business association to carry on the intended venture, and is not strictly a separate business vehicle. The courts have not given the joint venture a precise meaning, nor regarded it as a legal concept distinct from the other forms.² A joint venture can be easily characterized as a general partnership, and its members supjected to joint and several liability.

Sole Proprietorships

A sole proprietorship is a business vehicle owned by one person but is not a legal entity separate from that person. Since the business being carried on is not legally separate, the owner owns the assets and receives the income of the business, and is liable for all of the debts and other obligations of the business. The owner's liability is unlimited, or at least to the extent that his liability is not covered by insurance, so that his personal assets as well as the assets of the business are at risk of being seized to satisfy the obligations of the business. While the owner may employ others in the business, he cannot employ himself, for a person cannot enter into a contract with himself.

There are few formalities in setting up a business as a sole proprietorship, and a sole proprietorship can be created without preparing or publicly filing any documents. Depending on the type of business to be carried on, a licence issued by municipal, provincial or federal authorities may be required. For example, a restaurant business requires a municipal licence,³ whereas a real estate brokerage business requires a provincial license,⁴ and an inter-provincial trucking business requires a federal licence⁵ in order to operate.

If the business of the sole proprietorship will be carried on using a name other than the name of the owner, that name must be registered under the Business Names Act.⁶ Failure to register the name deprives the owner from maintaining an action in connection with the business in an Ontario court without leave of the court, yet failure to register does not relieve the owner from liability under a contract using the name.⁷ Registering a business name does not prevent others from registering a similar or even identical business name, although the owner may sue the registrant of another business name if the other name is deceptively similar.⁸

A sole proprietorship is easily dissolved without the preparation or public filing of any documents, although a registered business name for it may have to be cancelled. When the owner dies, the sole proprietorship business devolves upon his estate trustee; should he become bankrupt, the business devolves upon the trustee in bankruptcy.

A sole proprietorship can be used by a corporation to operate or market one of its businesses separately from its other businesses, instead of incorporating the business as a separate supsidiary. This business is often regarded as a division of the corporation but it is not a separate legal entity. Consequently, the corporation is liable for the debts and other obligations of the division. The division may use a business name which is different from the corporation's name provided that name is registered under the Business Names Act. However, its corporate name as well as the registered business name should appear on all of its invoices, cheques, purchase orders and contracts.⁹

A similar approach may be taken by a foreign corporation wishing to carry on business in Ontario. Instead of incorporating a separate supsidiary, a foreign corporation may simply prefer to carry on its Ontario business directly through a branch operation. Because a foreign branch, like a division, is part of, and not legally distinct from, the corporation which creates it, the liabilities of the branch are those of the corporation. However, unlike the division of an Ontario corporation, a foreign branch must obtain an extra-provincial licence under the Extra-Provincial Corporations Act.¹⁰ When applying for an extra-provincial licence, the foreign corporation must file a NUANS name search report, an application for licence, an appointment of an Ontario agent for service, and a certificate issued by the foreign corporation's home jurisdiction certifying the corporation is in good standing.

Taxation of Sole Proprietorships

The income earned by a sole proprietorship business is included, and all losses incurred by the business are deducted, when calculating the owner's income from all other sources during the year. The owner does not file a separate federal or provincial tax return for the business. If the business losses exceed the other income of the proprietor for the year, they may carried back 3 years and carried forward 10 years¹¹ to be offset against any other income in those years. This ability to offset losses against other income often justifies keeping a business as a sole proprietorship until it becomes profitable, at which time it can be advantageous to convert it to a corporation. If the business is a division of a corporation, its income and losses are effectively consolidated with those of the corporation generally.

Unlike the shareholder of a corporation, a proprietor cannot defer income and the payment of tax by retaining earnings in the business, but does avoid the double taxation, discussed in more detail below, which corporations and their shareholders experience.

The $500,000 lifetime capital gains exemption¹² cannot be used when the sole proprietor sells the business because such exemption only applies to gains from the sale of "qualified small business corporation shares". Consequently, it is common practice for a sole proprietorship business to be transferred under section 85 (1) of the Income Tax Act to a new corporation, with the proprietor receiving shares of the corporation in return, before the shares of the new corporation are sold to a third party.

Partnerships

A partnership is a business vehicle owned by two or more persons, and like a sole proprietorship, is not a separate legal entity at common law. Consequently a partner cannot be both a partner and an employee of the partnership. However, partners can sue or be sued in the name of the partnership, giving the appearance of a separate legal status for litigation purposes.¹³

In Ontario, there can be general partnerships, limited partnerships, or limited liability partnerships. A partnership is defined in the Partnerships Act¹⁴ as a legal relationship between two or more persons "carrying on a business in common with a view to profit".¹⁵ However, an agreement to share gross returns does not of itself create a partnership, nor does the ownership of joint property of itself create a partnership, regardless of whether the profits from the property are shared by the owners or not.¹⁶

General Partnerships

The Partnerships Act provides that all of the partners in a general partnership are jointly liable for the debts and other obligations of the partnership, including those which arise from any act or omission of any partner while acting in the ordinary course of the partnership's business.¹⁷ Each partner is an agent of the partnership and the other partners, and when carrying on partnership business, a partner binds all of the partners under the laws of principal and agent.¹⁸ A general partner's liability is unlimited, or at least to the extent that his liability is not covered by insurance, so that his personal assets as well as the assets of the partnership are at risk of being seized to satisfy the obligations of the partnership business.

There aren't necessarily any greater formalities in setting up business as a general partnership than there are for setting up business as a sole proprietorship. Depending on the type of business to be carried on, a licence issued by municipal, provincial or federal authorities may be required. If the general partnership is being carried on using a name which differs from the names of all of its partners, the name should be registered under the Business Names Act.¹⁹ Failure to register the name deprives a partner from maintaining an action in connection with the business in the Ontario courts without leave of the court.²⁰

While there is no requirement that the general partners enter into a written partnership agreement, many general partnerships have a written agreement to avoid the application of various provisions of the Partnerships Act.²¹ Such a written agreement might attempt, for example, to override section 24, which provides that all of the general partners are entitled to share equally in the capital and profits of the partnership's business and to take part in the management of the business, and which effectively gives each partner a veto over the admission of any new partner.

A general partnership is easily dissolved without the preparation or public filing of any documents, although a registered business name for it may have to be cancelled. Unless the partnership agreement otherwise provides, a partnership is terminated pursuant to sections 32 and 33 of the Partnerships Act if a partner withdraws from the partnership, dies or becomes insolvent.

Limited Partnerships

While a limited partnership is still a partnership, and many provisions of the Partnerships Act apply to limited partnerships, the Partnerships Act is supject²² to the provisions of the Limited Partnerships Act.²³ Limited partners are afforded limited liability provided certain rules are complied with. A limited partnership must have one or more general partners and one or more limited partners,²⁴ although the same person can be a general as well as limited partner.²⁵

There are more formalities in setting up a limited partnership than a general partnership. A written limited partnership agreement must be entered into,²⁶ and a declaration of limited partnership must be publicly filed under the Limited Partnerships Act²⁷ and renewed every five years. The name of the limited partnership may not contain the name of a limited partner who is not also a general partner, and the name may contain the word "limited" only as part of the expression "limited partnership".²⁸

A declaration of dissolution must by publicly filed if the limited partnership is dissolved.²⁹ A limited partnership is deemed to be dissolved upon the retirement, death or mental incompetence of a general partner or dissolution of a corporate general partner unless the business is continued by the remaining general partners pursuant to their right to do so contained in the limited partnership agreement or with the consent of all of the remaining partners.³⁰

Ordinarily it is the limited partners, not the general partners, who invest most of the capital in the limited partnership's business and share in most of its profits, although the limited partners may invest only money or property but not services.³¹ While a limited partner may lend money to the limited partnership, he cannot take security from the partnership for any loan, or receive money from the partnership in priority to another creditor who is not a partner if the partnership's assets are insufficient to discharge the obligations owed to that creditor.³²

The liability of a limited partner is limited to the amount of his contribution to the limited partnership unless he takes part in the control of the limited partnership's business.³³ Losses of the limited partnership are allocated amongst the partners in accordance with the limited partnership agreement, provided that once the contributions of the limited partners have been depleted, the remaining losses are to be met by the general partners jointly. Since the general partners have unlimited liability for the debts and other obligations of the limited partnership, general partners are usually separate corporations.

Since limited partners do not have unlimited liability for the acts and omissions of other partners, and since limited partnerships are ordinarily used to facilitate investment, the restrictions on partnership admission and transferability of partnership interests found in general partnership agreements usually do not apply to limited partners.

Limited Liability Partnerships

Although professionals are not permitted to carry on their professional practice through a limited partnership, they may do so through a limited liability partnership, or LLP, which is addressed in specific sections of the Partnerships Act.³⁴ An existing general partnership of professionals can be converted into an LLP by the partners, either by way of a new partnership agreement or an amendment to their existing partnership agreement. The LLP upon conversion acquires all of the assets and assumes all of the liabilities of the former general partnership, but those who were partners of the general partnership continue to be liable for such liabilities.

But after conversion, the partners of the LLP enjoy some limited liability, though not as limited as if they were limited partners in a limited partnership. A partner in an LLP is not liable for the debts and other obligations of the LLP which arise out of the negligence of the other partners or of an employee or agent of the LLP in the course of the LLP's professional practice. But he is still liable for his own negligence or for the negligence of someone under his control or supervision, and is still liable along with the other partners for the partnership's ordinary trade debts.

The formalities in setting up an LLP are not as extensive as setting up a limited partnership. A new partnership agreement must be entered into or an existing partnership agreement amended, and the business name of the LLP, whether newly created or converted from an existing general partnership, must include the words "limited liability partnership" or the abbreviation "LLP", and must be registered under the Business Names Act.

Taxation of Partnerships

A partnership is not a separate taxable entity, although any income or loss from the partnership business is calculated at the partnership level and then allocated amongst the partners as prescribed in their partnership agreement. Various expenses are first deducted from the partnership's revenues to arrive at the partnership's net income or loss. Then the partner's share of that net income or loss is included in the partner's income from all sources for tax purposes and taxed at his marginal tax rate, whether or not any of the partnership's income is actually distributed to the partner. The partners file their own tax returns and pay tax on the partnership income allocated to them, whereas the partnership files only an information return.

Certain sources of income and loss, such as those relating to capital gains or interest, retain their initial character and "flow though" to the partner to be used in calculating his overall income. Capital cost allowance must be claimed at the partnership level and therefore the partners must agree amongst themselves how much capital cost allowance they want the partnership to claim in any given year. They then receive their share of the amount claimed whether they can use it or not.

This ability to flow through partnership losses as well as income to the partners is useful in start-up situations where a business is unlikely to be profitable for a while. However, any losses of a limited partnership which are allocated to a limited partner can only be deducted by that limited partner to the extent of the "at risk amount" he has invested in the limited partnership. That amount is generally the adjusted cost base of his partnership interest plus his share of partnership income for the fiscal year, less any amounts he owes to the partnership and any benefits he might receive as protection from any loss as a partner.³⁵

Unlike a sole proprietor who owns the underlying assets of the proprietorship business, a partner owns an interest in the partnership, not the underlying assets of the partnership, and therefore can incur a capital gain or loss when disposing of his partnership interest. Assets can be transferred on a tax deferred "rollover" basis to a partnership, as well as from the partnership to the partners on dissolution, or upon the conversion of the partnership into a corporation.³⁶

As with a sole proprietorship, the $500,000 lifetime capital gains exemption cannot be used when a partner sells his partnership interest in the partnership because such exemption only applies to gains from the sale of "qualified small business corporation shares". Therefore, the assets of a partnership business are generally transferred under section 85 (2) of the Income Tax Act to a new corporation, with the partners receiving shares of the corporation in return, before the shares of the new corporation are sold to a third party.

Co-Ownership

Like a partnership, co-ownership can serve as a business vehicle which is owned by two or more persons and which co-owns certain assets or facilities requiring some form of joint management. Co-ownership, like a sole proprietorship and partnership, does not represent a separate legal entity. It usually entails a joint property interest and a right of mutual control, but unlike a partnership, limits its objectives to a single undertaking or a limited number of undertakings. It is often viewed more as a vehicle for holding, managing, and improving an investment rather than for carrying on a trading business, and for generating "passive" rather than "active" income and gains.

Parties to a co-ownership often try to distinguish their relationship from a partnership, expressly disclaiming in their co-ownership agreement any intent to create a partnership or any liability for the acts or omissions of their co-owner. However, such self-serving disclaimers may not be effective to avoid a finding of partnership by a court, especially if the co-owned investment represents an ongoing business rather than specific income-producing assets. Out of an abundance of caution, the parties may even go so far as to retain an independent operator or manager for all of their co-owned assets to avoid the inference of partnership.

Unlike ownership of property by a partnership, ownership of property by two or more co-owners ordinarily involves the holding by each owner of his own separate interest in the property which he can deal with as he chooses, supject to any agreement he may have entered into with his co-owners. Partners, on the other hand, have an interest in the partnership but not in any specific partnership property.

While a co-ownership may continue upon the death of a co-owner with the estate of the deceased assuming his co-ownership interest, the co-ownership agreement often provides the surviving co-owner(s) with a right to purchase the interest of the deceased. A similar right to purchase, coupled with a right to sell, is often provided in the event a co-owner wishes to withdraw. If the agreement fails to provide such a buy-sell mechanism, a co-owner wishing to withdraw may consider applying for a partition and sale of the co-owned properties under the Partition Act.³⁷

It is generally contract law and the co-ownership agreement between the parties which circumscribes their relationship, given the absence of a statute governing co-owners in the same way as the Partnerships Act governs partners. However, there may be specific statute and case law which governs the use of the co-owned assets and any applicable rights and obligations. Real property, intellectual property, aircraft, rolling stock, ships, and telecommunications equipment are all examples of assets which can be the supject of co-ownership agreements and which are governed by separate legislation. As a result, the formalities in setting up a co-ownership vehicle can be more complicated than the co-ownership agreement itself, depending upon the licensing and other registration requirements imposed by such separate legislation.

Taxation of Co-Ownership

Co-ownership is not treated as a separate person for tax purposes, and consequently discretionary deductions are not calculated at the co-ownership level but are instead claimed separately by each of the co-owners. The tax effect of co-ownership is the same as if the co-owners carried on the business separately as sole proprietors.

For example, if the co-owners wish to claim capital cost allowance on the co-owned property at different times or at different rates from each other, they are able to do so.³⁸ Partners don't have the same flexibility when it comes to partnership property. Since co-owners make their own claim for capital cost allowance based upon their own separate interests in the property, what they claim can depend upon whether they have taxable income or losses in any given year. A co-owner with losses will usually defer claiming capital cost allowance until a year with income, whereas a co-owner with income will usually claim the maximum capital cost allowance available in order to reduce currrent taxes payable.

Trusts

Like a partnership and co-ownership, a trust can serve as a business vehicle owned by two or more persons, although ownership is split between the "legal" ownership of the trustee and "beneficial" ownership of the beneficiaries. It, like a sole proprietorship, partnership or co-ownership, does not represent a separate legal entity but is merely a relationship between the trustee and beneficiaries regarding the assets held in trust.

A trust can be created by way of a declaration of trust or trust agreement under which business assets can be transferred from the "settlor" to a trustee, who is authorized to deal with the assets on behalf of the beneficiaries in a prescribed manner.³⁹ While the declaration of trust or trust agreement may represent the only formality in setting up a trust, many trusts used as business vehicles can involve quite complicated structures and documentation, as outlined below.

As with co-ownership, the trust is viewed as more suitable for holding and managing an investment and receiving "passive" income than it is for operating a trading business which earns "active" income. The traditional mandate of the trustee to conserve trust assets and avoid risk is seen as inconsistent with the nature of an operating business which often disposes of assets and takes risk when deemed necessary, including going into debt. A trustee is generally under a duty to invest trust property in any form of property in which a prudent investor might invest.⁴⁰

Consequently, inter vivos trusts have traditionally been used to hold income-producing assets, such as office buildings and oil fields generating a constant stream of rental or royalty payments. More recently, however, trusts are being used to acquire and hold a broad range of business assets, sometimes directly, but mostly indirectly through a separate corporation or limited partnership which carries on the actual day-to-day operations of such business assets through a management services agreement.

Trust beneficiaries are liable for the debts and other obligations of the trust only in exceptional circumstances, such as when they might assume the duties of the trustee. However, if they hold units in a mutual fund trust which is governed under Ontario laws and is a reporting issuer under the Securities Act,⁴¹ they are not liable for the liabilities of the mutual fund trust as beneficiaries by reason of the Trust Beneficiaries' Liability Act, 2004.⁴²

Trustees, on the other hand, can be liable for the debts and liabilities of the trust as well as being liable to the beneficiaries for a possible breach of trust. When a trustee contracts with third parties, he is personally liable on those contracts even though he may be entitled to recover from the trust property for the outgoings from his own pocket. A third party is unaffected by the insufficiency of the trust property to meet any action for damages the third party may have against the trustee.⁴³

However, in his contract with the third party, a trustee will ordinarily try to limit his liability for breach of contract to the extent of the trust property. As he is also personally liable to third parties for any torts which he or any of his agents commits, he also will ordinarily obtain insurance to cover off this liability and recover his cost of the insurance premium from the trust property. In light of this personal liability faced by trustees, the trustees of trusts used as business vehicles are usually separate corporations.

Taxation of Trusts

Unlike a sole proprietorship, partnership, or co-ownership, a trust is a separate taxable entity, even though it is not a separate legal entity, and is taxed at the highest individual marginal tax rate.⁴⁴ While a trust cannot flow through expenses and losses to its beneficiaries to be offset against their other income in the same way that a sole proprietorship, partnership or co-ownership can, a trust can flow through income. A trust is able to deduct from its income any amounts it has paid to its beneficiaries during the year, which amounts are then included in the beneficiaries' incomes for that year. These amounts do not lose their original character, such as dividends or capital gains, and are taxed as such in the hands of the beneficiaries.

As a taxable entity, a trust must take various deductions such as capital cost allowance at the trust level, which cannot be taken at the beneficiary level. Any non-capital business losses of the trust can be carried back 3 years and forward 10 years⁴⁵ to be applied against trust income in such years. Since business assets can't be transferred into a trust on a tax deferred "rollover" basis (unlike assets transferred into a partnership or corporation), such assets are deemed to be disposed of at fair market value when they are transferred to a trust.

The main reason for using the trust as a business vehicle is the ability to avoid the "double taxation" which Canadian corporations and their shareholders experience. As discussed in more detail below, income from a business is taxed when it is earned by a corporation, and then taxed again when it is received by the shareholders in the form of dividends. Income earned by a trust is taxed only to the extent it stays with the trust; if it's paid to the beneficiaries, the beneficiaries pay tax on it instead.

Some smaller, closely-held corporations use trust vehicles to acquire and hold business assets to avoid this "double taxation" and achieve certain income splitting and estate planning goals, with various family members participating as trust beneficiaries. However, it is with larger, publicly-held corporations where the use of the "business trust" has become so evident. These larger corporations effectively turn themselves into publicly-held mutual fund trusts,⁴⁶ where the beneficiaries of the trust are the holders of the mutual fund units.

While there are many variations on the structures used by these business trusts, a simple structure often involves the sale of trust units to the public and the investment by the trust of the sale proceeds in an entity which operates the business. Most of the proceeds are invested by way of a loan to the operating entity, and most of the operating entity's net operating revenues are paid to the trust as interest on the loan. The interest paid is tax-deductible, thereby leaving the operating entity with little taxable income. The amounts received by the trust are then paid to the unit holders and taxed in their hands. The operating entity is often a corporation, affording the trustee limited liability as a shareholder, but can also be a limited partnership. With the operating entity a corporation, corporate tax is minimal because of the interest deduction, and since the only income being taxed is in the hands of the beneficiaries, the double taxation associated with corporate earnings is effectively eliminated.

This simple structure is often altered by interposing an additional entity, usually another corporation or limited partnership, which then holds the operating company. The operating company distributes most of its net operating revenues, as interest under a large loan, to the holding entity which in turn distributes most of its revenues, again as interest under a large loan, to the trust. Taxes are therefore minimized at the operating and holding entity levels, and since the mutual fund trust is a non-taxable entity, only distributions to the unitholders are taxed. If the unitholders themselves are tax exempt, such as pension funds and RRSPs, payment of tax on the revenues originally earned by the operating company can be significantly deferred until distribution to the ultimate beneficiaries.

An inter vivos trust is deemed for tax purposes to have disposed of its property every 21 years at fair market value,⁴⁷ thereby creating a potentially large liability for the trust. A mutual fund trust, however, is not caught by this deemed disposition rule, and is therefore used as the vehicle for publicly-traded business trusts.

Corporations

Unlike the other business vehicles mentioned above, a corporation is a legal entity separate from its owners. Therefore the owners, or shareholders, are generally not liable for the debts and other obligations of the corporation.⁴⁸ They are, however, liable to a certain extent in particular circumstances. For example, they are liable to repay any distributions they may have received as a return of capital when the corporation was insolvent,⁴⁹ or to repay any distributions they may receive upon the corporation's dissolution to the extent of any amounts still owing to the corporation's creditors.⁵⁰

Essentially their liability is limited to the value of the money or property they have transferred to the corporation in exchange for their shares. If the assets of the corporation are insufficient to fully satisfy the claims of the corporation's creditors, the shares held by the shareholders can become worthless, but the shareholders have no personal liability to make up for the insufficiency of the assets.

Unless otherwise restricted in its articles of incorporation, a corporation has all the rights, powers and privileges of a natural person.⁵¹ In the absence of being dissolved voluntarily by its shareholders or involuntarily by others, a corporation has perpetual existence. It continues despite the death of a shareholder or the sale of his shares. Liquidation and dissolution of a corporation can be a lengthy and expensive process, requiring the receipt of tax clearance certificates and filing of articles of dissolution.

The need to prepare and file articles of incorporation and prepare by-laws, resolutions and share certificates to organize a corporation suggests a greater formality in setting up a corporation in contrast to the other forms of business vehicles discussed above. However, setting up a corporation doesn't necessarily involve more time and expense than setting up the others with the exception of a sole proprietorship. The preparation of agreements to create a partnership, trust or co-ownership can be more time consuming than forming a corporation unless a shareholders agreement for the corporation is being prepared at the same time.

The main impediment to a speedy incorporation is the need for the corporate name to be distinctive or at least not confusing with the names of other business vehicles and trade marks.⁵² Because a corporation incorporated under the Canada Business Corporations Act (the "CBCA") can carry on business using its corporate name in any province or territory, obtaining approval to use a proposed name for a CBCA corporation from Corporations Canada can be difficult. Consequently, business owners often apply for CBCA incorporation by using simply a numbered name to get around this hurdle, and then supsequently have the numbered corporation register the name they wish to use as a business name under the Business Names Act.

Using a corporation instead of the other vehicles which are not separate legal entities can allow an owner to also be an employed manager of the business, or can allow an owner to be separate from management. Furthermore, because the shares of a corporation consist of a "bundle of rights" and such rights can be split up amongst a number of different classes, a corporation can be useful in achieving certain estate planning goals of its owners, as discussed in more detail below.

Jurisdiction Shopping

When selecting a corporation as the preferred vehicle to carry on business in Ontario, the choice is usually made between incorporating under either the Ontario Business Corporations Act (the "OBCA") or the CBCA. While businesses which intend to be carried on only within Ontario generally incorporate under the OBCA, businesses intending to operate in a number of provinces or those which are foreign owned tend to favour CBCA incorporation. Although both statutes are supstantially similar, there are some differences between them which may cause a business owner to prefer one over the other.

For example, the CBCA provides greater name protection since the name of a CBCA corporation can be used throughout Canada, whereas the right to use the name of an OBCA corporation is given only for Ontario. The CBCA also allows for a greater percentage of non-resident directors; a majority of the directors of an OBCA corporation must be Canadian residents,⁵³ whereas only 25% of a CBCA corporation's directors must be residents.⁵⁴ The CBCA no longer restricts related party financial assistance, whereas the OBCA requires that shareholders be notified that such assistance has been given. And the CBCA, unlike the OBCA, allows for private company "squeeze-outs" under which the interest of shareholder can be effectively terminated without the shareholder's consent or without being given an interest in other shares of equivalent value.

However, the OBCA might be preferred in order to avoid the delay and scrutiny often experienced when attempting to obtain name clearance for incorporation under the CBCA, or to avoid the possible application of the proxy solicitation requirements under the CBCA which are applicable to non-distributing corporations with more than 50 shareholders.⁵⁵

Also, professionals in Ontario such as doctors, dentists, accountants and lawyers wishing to incorporate their practices may do so under the OBCA but not under the CBCA.⁵⁶ If they do incorporate under the OBCA, their professional corporation will be supject to certain special rules, the most important being that the professional corporation cannot be used by the professional to limit his personal liability for negligence in his practice.⁵⁷ Even though the professional corporation and its shareholders may enjoy the tax advantages afforded to small business corporations, they are not insulated from professional liability claims from patients or clients.

Among the other rules governing a professional corporation, all of the corporation's issued shares must be legally and beneficially owned by one or more members of the same profession, all directors and officers must be shareholders, and the corporation's business must be confined to carrying on the professional practice or to activities ancillary to the practice. The words "professional corporation" or the French equivalent must appear in its corporate name.⁵⁸

For U.S. based owners, incorporating a business under the OBCA or CBCA may not be as desirable from a tax perspective as incorporating a business as an unlimited liability company under the Nova Scotia Companies Act⁵⁹ or as an unlimited liability corporation under the Alberta Business Corporations Act⁶⁰ (collectively, "ULCs"). As discussed in greater detail below, a ULC can be a "disregarded entity" for U.S. income tax purposes and treated much like a partnership permitting the "flow through" of profits and losses to its U.S. owner, even though it is regarded as a corporation for Canadian tax purposes.

However, despite its U.S. tax advantages, there are disadvantages to using a ULC as a vehicle to carry on business in Canada, not the least of which is the potential loss of limited liability to its shareholders. In the case of a Nova Scotia ULC, its shareholders lose their limited liability if the ULC is wound up or otherwise liquidated and its assets are insufficient to pay its liabilities and liquidation expenses. They are liable for the shortfall.⁶¹ In the case of an Alberta ULC, the liability of its shareholders is slightly broader, since a creditor has a direct claim against the shareholders for the liabilities owed to the creditor without having to first proceed against the ULC or wait for a winding-up or liquidation.⁶²

In addition to its slightly narrower liability for shareholders, a Nova Scotia ULC might be preferred over an Alberta ULC because of the absence from the Nova Scotia Companies Act of the Canadian residency requirements,⁶³ personal statutory liability for unpaid employee wages⁶⁴ and improper dividends and share redemptions,⁶⁵ and restrictions on the corporate indemnification of directors,⁶⁶ which are imposed upon the directors of Alberta ULCs.

However, an Alberta ULC might be preferred over a Nova Scotia ULC given the recognition of unanimous shareholder agreements⁶⁷ and the relative ease of converting an existing corporation created elsewhere⁶⁸ under the Alberta Business Corporations Act. If an existing corporation is to be converted into a Nova Scotia ULC, it has to first be continued into Nova Scotia and then amalgamated by way of court order with an already formed Nova Scotia ULC, thereby triggering a year-end for each of the amalgamating companies and necessitating the preparation of additional financial statements for them while affecting their ability to carry forward previous tax losses.

As well as considering incorporating or continuing an existing corporation in Nova Scotia or Alberta as a ULC because of its tax advantages, business owners may consider incorporating other than under the OBCA or CBCA in order to avoid director residency requirements. If it is not possible to easily satisfy the residency requirements under the OBCA or CBCA as discussed above, New Brunswick, British Columbia, Nova Scotia and Quebec are among those Canadian jurisdictions which lack such requirements and may be considered.⁶⁹

Instead of attempting to decide which Canadian jurisdiction to use for the incorporation of a Canadian supsidiary, a foreign corporation wishing to carry on business in Ontario may simply prefer to carry on its business directly through a branch operation. As mentioned above, because a foreign branch is part of, and not legally distinct from, the corporation which creates it, the liabilities of the branch are those of the corporation. Foreign corporations must obtain an extra-provincial licence under the Ontario Extra-Provincial Corporations Act.

Taxation of Corporations

A corporation is treated as an entity separate from its shareholders for income tax purposes. Unlike sole proprietorships and partnerships, business losses incurred by a corporation are effectively "trapped" in the corporation and cannot be flowed through to its shareholders. A shareholder's share of the corporation's income or loss cannot be added to the shareholder's personal income or loss from other sources to determine his overall taxable income. An exception to this relates to a shareholder's loss on shares in a small business corporation,⁷⁰ 50% of which can be deducted by the shareholder against his other income as an "allowable business investment loss".

If the corporation's income is paid out to the shareholders as dividends, the amount of the dividends will be taxed as income in the hands of the shareholders, although at a lower rate than other income earned by the shareholder. If the shareholder is a Canadian corporation, the dividend can be taken into the shareholder's income without tax, supject to certain exceptions.⁷¹

Although there are tax advantages to using other vehicles to carry on business, there is an advantage to using a corporation to carry on a smaller business. A "Canadian-controlled private corporation"⁷² earning active business income which qualifies for the "small business deduction" is taxed at approximately one-half of the normal corporate tax rate. This lower tax rate applies to the first $300,000 of active business income earned by the Canadian-controlled private corporation. Corporations often pay additional salaries and bonuses in an effort to keep their income below this limit.

Even if the corporation's income does not qualify for the small business deduction, there is still a tax deferral provided by leaving corporate income in the corporation instead of paying it out to the shareholders. Retaining income to defer the payment of tax is a choice unavailable to proprietorships and partnerships, and individual proprietors and partners can be taxed on their proprietorship or partnership income at higher marginal rates than the corporate tax rate. This deferral for corporations, however, does not apply to investment income earned by the corporation.

Assets can be transferred to a corporation on a tax deferred "rollover" basis, as well as transferred amongst related corporations on a rollover basis.⁷³

As mentioned above in connection with the sale of sole proprietorship or partnership businesses, the shareholders of a corporation used as a business vehicle are entitled to access their $500,000 lifetime capital gains exemption⁷⁴ upon the sale of their shares provided their shares are "qualified small business corporation shares". Ordinarily they must hold their shares for two years before selling them, unless they received their shares in exchange for assets transferred to the corporation, which can occur when a sole proprietorship or partnership is converted into a corporation. At least 50% of the assets of the corporation must have been used in carrying on active business during the previous 2 years, and 90% so used at the time the shares are sold.

As mentioned above, using a ULC as a vehicle to carry on business has tax advantages for a U.S. based owner. While a ULC will be treated as a Canadian corporation for Canadian tax purposes, it can elect to be a "disregarded entity" for U.S. tax purposes pursuant to the "check-the-box regulations"⁷⁵ under the U.S. Internal Revenue Code so that it is taxed as if its assets and liabilities were held directly by its owner. This gives it "flow-through" status and is treated under U.S. tax law as a branch, if it has one owner, or as a partnership, if it has more than one owner, permitting its profits and losses to be taxed in the hands of its owners.

This election can give rise to a number of tax advantages. For example, any losses incurred by a ULC which is a supsidiary of a U.S. based owner can be used to reduce the owner's U.S. taxable income, whereas such losses would not be deductible from the owner's taxable income if the ULC elected to be treated as a corporation. Furthermore, if a U.S. buyer acquires all the shares of a ULC from a Canadian seller, the sale will be treated as a share sale under Canadian tax law, giving rise to a possible capital gain and eligibility for use of the seller's $500,000 lifetime capital gains exemption. But the sale can be treated as an asset sale for U.S. tax purposes, allowing the U.S. buyer to increase its cost base of the assets acquired and to claim more U.S. depreciation expense than could otherwise be claimed.

For those foreign corporations wishing to carry on business in Ontario through a branch instead of through a separate Canadian supsidiary, they will still be taxed on the income of their branch earned in Canada⁷⁶ at the regular corporate tax rates, as well as supjected to a further "branch tax"⁷⁷ which is calculated upon the branch's net income after deduction of domestic taxes and certain investment allowances. Although this additional branch tax might encourage a foreign corporation to use a Canadian supsidiary instead of a branch, the supsidiary would still be taxed on its income at regular corporate tax rates, and any dividends paid to its foreign parent would be supjected to withholding taxes.

If the business to be carried on in Ontario looks as if it may sustain losses during its start-up period, which can be used by the foreign corporation to reduce its own domestic taxes payable, a branch may be preferable until the business becomes profitable. At that time, the branch's assets can be transferred to a new Canadian supsidiary on a tax deferred basis under section 85 (1) of the Income Tax Act.

Comparing the Alternatives

Even though a business owner has a number of alternative vehicles to choose from when setting up a business, not every vehicle will be suitable for that business. The particular circumstances of the business may reduce the number of eligible vehicles to just one or two. For example, if there is to be only one owner of the business, the choice of which vehicle to select is between the sole proprietorship and the corporation.

Listed below are some of the major factors to be considered when deciding which vehicle to use.

Type of Business

The type of business to be carried on may determine which vehicle is to be selected, or at least restrict the type of vehicle which may be selected. If the business will involve the active carrying on of a trade as opposed to a more passive holding and improving of property and other assets, co-ownership or a trust arrangement may not be the most appropriate vehicle to choose.

If a vehicle is needed to carry on a professional practice, a sole proprietorship, general partnership, LLP or professional corporation may be appropriate, but not a trust, co-ownership or business corporation.

For certain types of businesses which are governed by special statutes, such as banks, insurance companies, co-operatives, or trust and loan companies, the vehicle to be used will be determined by the particular statute, so that incorporation under either the OBCA or CBCA will not be an option.

Costs

The legal costs of creating a corporation ordinarily exceed those associated with creating a sole proprietorship or general partnership, although the cost of preparing a comprehensive partnership agreement can greatly exceed the costs of incorporation unless a shareholders agreement is being prepared for the corporation. In the absence of such agreements, the registration and filings costs are generally greater for corporations at the outset.⁷⁸

Such is not always the case with the other business vehicles discussed above. The preparation of agreements to create a trust or co-ownership as well as a general partnership can be more time consuming than forming a corporation even if a shareholders agreement for the corporation is prepared. The costs of forming a limited partnership often exceed the costs incurred in forming a corporation, both of which are greatly exceeded by the costs of forming a mutual fund trust.

The legal and accounting costs incurred to maintain a corporation are higher than for sole proprietorships, general partnerships, trusts and co-ownerships, given the financial statement and records requirements imposed upon a corporation by statute⁷⁹ and the need for directors' and annual shareholders' meetings. However, they are generally less than the ongoing costs of maintaining a limited partnership or mutual fund trust. Consequently, these costs may make a corporation, limited partnership or mutual fund trust an unsuitable vehicle for a "short term" or "limited purpose" venture, and favour a partnership or co-ownership instead.

Names

Registering a business name under the Business Names Act for a sole proprietorship or partnership is easily accomplished when compared to the difficulties that can be faced when attempting to clear a name for incorporation purposes.

As mentioned above, the main impediment to a speedy incorporation is the need for the corporate name to be distinctive or at least not confusing with the names of other business vehicles and trade marks. Because a CBCA corporation can carry on business using its corporate name in any province or territory, approval to use a proposed name for a CBCA corporation from Corporations Canada is not easily obtained. However, since proposed names for OBCA corporations are not supject to similar scrutiny by the Ontario Ministry of Government Services, incorporating under the OBCA may be preferred.

Limited Liability

Since a sole proprietor is personally liable for the debts and obligations of the proprietorship business, a corporation is often selected instead to carry on the business so that the owner's liability to creditors of the business is limited to the amount of his investment in the business as a shareholder.

Similarly, since every partner in a general partnership is personally liable for the debts and obligations of the partnership business, a corporation or limited partnership is often selected instead to limit the partner's liability to the amount he has invested in the business, unless he is also the general partner of a limited partnership, or a partner of an LLP. If a limited partner is also involved in managing the limited partnership business, perhaps as a director or employee of the general partner, he will lose his limited liability. Since even a limited partnership involves unlimited liability for at least one party, namely the general partner, a corporation is usually the preferred vehicle if limited liability is sought for all of its owners.

Because incorporation provides limited liability to its owners, it is used to augment any insurance coverage a business may obtain, and to provide protection to the owners against risks which may not otherwise be insurable. For sole proprietorships and partnerships, incorporation may be more affordable than insurance in covering supstantial risks.

However, carrying on a business as a corporation instead of a sole proprietorship or general partnership doesn't necessarily ensure limited liability for its owners, given that the shareholders of closely-held corporations are often required to provide personal guarantees in order to obtain bank financing and lease office premises. While the shareholders may still enjoy limited liability from the claims of the corporation's trade creditors, their personal assets can be at risk to the corporation's banks and landlords under such guarantees. Furthermore, as they often serve as directors, they can become personally liable for certain liabilities of the corporation, such as unpaid employee wages and source deductions.

Using a trust vehicle to carry on business imposes liability on the trustee, since he can be liable for the debts and liabilities of the trust as well as be liable to the beneficiaries for a possible breach of trust. As mentioned above, when a trustee contracts with third parties, he is personally liable on those contracts even though he may be entitled to recover from the trust property. For this reason, a corporation is often used as the trustee. Trust beneficiaries, on the other hand, are liable for the debts and other obligations of the trust only in exceptional circumstances, such as when they might assume the duties of the trustee, and are not liable if they are beneficiaries of a mutual fund trust.

Duration

The intended life of the business can influence which vehicle is to be chosen. While a corporation has perpetual existence or unlimited duration, a sole proprietorship, partnership and co-ownership generally have limited continuity. An inter vivos trust, although not a mutual fund trust, is deemed under the Income Tax Act to have disposed of all of its assets at the end of every 21 years.

Upon the death of the proprietor, a sole proprietorship terminates and the proprietor's estate generally attempts to dispose of the business assets. A partnership terminates upon the death or withdrawal of a partner unless the partnership agreement otherwise provides. A co-ownership may continue upon the death of a co-owner with the estate of the deceased assuming his co-ownership interest, unless the co-ownership agreement otherwise provides, but the attempted withdrawal by a co-owner ordinarily involves the partition and sale of the co-owned properties. A trust may continue upon the death or withdrawal of the trustee so long as a successor trustee is appointed, whereas the death of a beneficiary does not affect the continuity of the trust unless no successor beneficiary is found to exist. A corporation continues on despite the death or withdrawal of a shareholder or director.

If a business depends upon the involvement of specific individuals, or if its survival beyond their death or withdrawal would be unlikely, then a sole proprietorship or partnership might be appropriate. For projects of a shorter term or finite duration, use of a co-ownership or partnership might be preferred over a corporation, especially since a corporation may not be as easily dissolved.

Guiding Law and Practice

If incorporated, a business is governed by well-established legislation and rules of practice. The CBCA and OBCA, along with the enormous volume of cases reported each year, provide comprehensive guidance on how a business is to be carried on by a corporation.

In contrast, partnerships and trusts, through the Partnerships Act and Trustee Act, do not have as comprehensive a legislative framework as corporations, and are generally governed instead by their respective partnership agreement or trust agreement and a sometimes confusing body of case law which has evolved over the last century. Co-ownership vehicles don't even have the benefit of specific legislation and rely instead on their respective co-ownership agreements and a fairly shallow body of case law for guidance.

The Limited Partnerships Act provides some assistance in addressing governance issues and clarifying rights and remedies in connection with limited partnerships, but the Trust Beneficiaries' Liability Act, 2004 only addresses the liability of holders of publicly-distributed trust units and fails to provide the kind of legislative direction over business trust governance which is in place in certain American jurisdictions such as Maryland.

The existence of a comprehensive legislative regime can be viewed positively by some business owners and negatively by others. Since many of the rules set out in the Partnerships Act can be varied or avoided in a partnership agreement, a partnership is often regarded as more flexible than a corporation when crafting the "unique" relationship among the partners. A co-ownership can offer even more flexibility.

On the other hand, many owners, and more importantly, potential investors, might prefer a corporation as the appropriate business vehicle because the respective rights and obligations of all of the parties are clearly set out. The statutory requirements for directors, annual meetings of shareholders, public filings and financial statements provide a certain level of accountability and transparency in corporations.

Income Splitting and Estate Planning

Some business vehicles are better suited than others to accomplish the income splitting and estate planning goals of the business owner. If the owner of a business wishes to split the income of the business amongst various members of his family, or pass on to them the potential appreciation in the value of the business, or to generally provide for the orderly transfer of ownership of the business to them, a sole proprietorship cannot achieve this, and anti-avoidance rules in the Income Tax Act covering artificial distributions to partners make this difficult for a partnership to achieve.⁸⁰ Income splitting for sole proprietorships and partnerships is generally limited to paying reasonable salaries to family members who are employees.

A corporation, however, can achieve this easily through the issuance of different classes of shares while at the same time, if the owner wishes, maintaining the owner's control over the business. Even after the owner dies, this can be achieved under the owner's will by distributing various classes of shares to designated beneficiaries, some or all of whom may not have any role to play in the supsequent running of the business. However, this may not be achievable through the use of a professional corporation given the requirement discussed above that all shareholders of a professional corporation must be members of the same profession.

For example, one class of shares can be given sufficient votes to control the corporation, to be held by a parent, whereas a second class can be given the potential to benefit from any appreciation in the value of the corporation overall, to be held by a child. The value of the class of shares issued to the parent can be "frozen", thereby limiting his future capital gains tax liability on such shares. Furthermore, different classes of shares can be issued to different family members with lower personal marginal tax rates, permitting different dividends to be paid to each of them and thereby lowering the total amount of tax payable on the family's income.

Because the corporation is a separate legal entity, it can enter into a number of different commercial relationships with family members as a means of flowing cash to them. It can pay interest to them on loans they may have provided to the corporation, salaries to them as employees, royalties to them as licensors of intellectual property, rent to them as landlords, and dividends to them as shareholders.

Employees

If an owner wishes to select a vehicle for the business which will allow him to give employees some amount of ownership as a reward for past services or as an incentive for future services, a corporation may be the only viable alternative. A general partner is not able to also be an employee of the partnership, and while an employee may be a limited partner of a limited partnership, a limited partnership interest can only be acquired by the employee on payment of money or property and not in consideration of the employee's services.

By using a corporate vehicle, an owner has a number of ways of enabling employees to acquire shares, generally through various forms of share purchase and option plans, and such shares may be of a different class with different rights than those held by the owner.

While giving an employee an ownership interest in the other business vehicles may involve a taxable disposition, the granting by a corporation of share options to an employee can be accomplished on a tax deferred basis.⁸¹ Employees acquiring shares of a "Canadian-controlled private corporation" as an employee benefit can defer paying tax on the benefit until they sell their shares. Even then, the benefit will be just one-half of the difference between the fair market value of the shares when they were acquired and the price paid by the employee for them.

Control and Management

The extent to which an owner desires to control or manage the business affects the choice of business vehicle to be selected. Unlike a sole proprietorship or partnership, a corporation differentiates between those owning and those managing, and through its possible use of different classes of shares, it can expand or restrict the rights of different shareholder classes to control and manage. Shareholders, acting as shareholders, do not have the right to manage the corporation, but the directors do, unless a unanimous shareholders agreement is in place for the corporation.

In other words, for owners preferring to be detached from the control and management of the business, and who may perceive their role as investors and not as managers, a corporation or limited partnership may be appropriate for their purposes. However, as minority shareholders or limited partners, they will be supject to the wishes of the majority.

General partners, on the other hand, do have the right to be involved in the control and management of the general partnership, given their role as agent for the partnership and for the other partners in connection with partnership business, as discussed above. An owner may very well desire the extent of involvement in managing the business which a general partnership provides.

But a general partnership may be undesirable for those owners preferring a looser association and looking to be fairly independent from one another, in light of the "mutual agency" of the partners as well as the fiduciary duty owed by the partner to the firm overall. The duty of a partner to account for any benefits derived by the partner using the partnership's property, name or business connection,⁸² or the duty to pay over all profits made by the partner in a business carried on by the partner of the same nature of the partnership's business,⁸³ may be inconsistent with a desire for freedom to operate. In such a case, a co-ownership may be the preferred vehicle.

Partnerships and trusts are more informal than corporations when it comes to control, since they are more creatures of case law when compared to corporations. However, between using a partnership or a trust, the trust may be more attractive because of its use of a party independent from the beneficiaries, namely the trustee, whereas the general partnership structure does not provide for a third party to hold and control the partnership's assets. Yet if the trust's beneficiaries are able to exercise considerable control over the trustee and do so, the trustee may be regarded by a court as their "agent" and their relationship might be categorized as a partnership, leaving the beneficiaries liable as principals. Limited partnerships, on the other hand, are able to achieve such independence by appointing a third party as the general partner.

Transferability of Interests

It is generally simpler to transfer shares in a corporation from an existing to a new shareholder, often requiring only a board resolution to approve the transfer, than it is to deal with the withdrawal of an existing general partner and addition of a new general partner, which often require that a new partnership agreement or an amendment to an existing partnership agreement be entered into by the partners. Unless the partnership agreement otherwise provides, all of the partners in a general partnership must approve the admission of a new partner. However, a limited partnership agreement can achieve for a limited partnership much of the flexibility available to corporations, with provisions dealing with the transfer of partnership interests and the admission of new limited partners.

While a corporation's shares may be easier to transfer, in theory, they may not be very marketable, in practice. A minority shareholder of a private company may be unable to sell his shares in the absence of a buy-sell agreement which places a compulsory obligation on the other shareholders to buy his shares. Similarly, in practice, if a partner wishes to withdraw from the partnership and the other partners are unable or unwilling to buy him out, the partnership may have to be dissolved and liquidated unless the partnership agreement otherwise provides.

Financing

While the factors discussed above under Guiding Law and Practice, Control and Management, and Transferability of Interests all influence how easily a particular business vehicle will be able to raise both debt and equity financing, there are other factors which affect debt financing.

Because a sole proprietorship is unincorporated, it is not possible for the proprietor to lend money to the business and claim any interest deduction for such expense. A partner, however, can lend money to the partnership and the partnership can claim an interest deduction. A limited partner may lend money to the limited partnership, but he cannot take security from the partnership for any loan, or receive money from the partnership in priority to another creditor who is not a partner if the partnership's assets are insufficient to discharge the obligations owed to that creditor.⁸⁴ Secured loans from a shareholder to a corporation are permissible, supject to the possible application of the "thin capitalization rules"⁸⁵ under the Income Tax Act which might restrict the deductibility of interest.

Use of limited partnerships or trusts as vehicles instead of corporations for publicly-traded investments can be limited by the inability to pledge the units of either vehicle in uncertificated form as security. In contrast, the securities of corporations can be pledged in uncertificated form pursuant to the OBCA,⁸⁶ but there is no comparable legislation for the pledging of limited partnership or trust units. However, should the proposed Uniform Securities Transfer Act come into force, this distinction should disappear.

Tax

A business owner considering which of the various alternative business vehicles to choose will usually be most influenced by the tax implications of the various vehicles before making a final choice. In light of the tax implications of each vehicle identified above, a brief summary of such implications for comparison purposes follows below, on the assumption that a business owner choosing a vehicle is not a "tax exempt" entity, such as a pension fund or RRSP.

As a rough "rule of thumb", a corporation for other than a small business will often be avoided at the outset for tax reasons. Unlike the other vehicles which are regarded as income "flow-through" entities for tax purposes, a corporation is taxed as a separate legal entity, and is often rejected as a result. Income earned by a corporation is taxed at the corporate level, and when paid out in the form of dividends to shareholders, is taxed again at the shareholder level. This form of "double taxation" does not occur with the other business vehicles.

With sole proprietorships and partnerships, the share of the expenses or losses incurred can be "flowed-through" and used to reduce the income earned by the proprietor or each partner from all other sources in order to reduce the tax payable on such other income. For this reason, partnerships are preferred over corporations as "tax shelters" by flowing through eligible expenses which enable the partners to "shelter" other personal income from tax. In contrast, the expenses or losses incurred by a corporation can only be used by the corporation to reduce its income but not by the shareholders to reduce their income. While a co-ownership can also effectively flow though expenses to its co-owners, a trust cannot flow through its expenses and losses to its beneficiaries to be offset by them against their other income.

Consequently, if a business is expected to incur losses, a sole proprietorship or partnership should be chosen so that its losses can be used to reduce other income (assuming other sources of income exist). Non-capital or "business" losses can normally be deducted from other income earned in the preceding 3 years and in the following 10 years. This is often the reason an unprofitable business remains a sole proprietorship or partnership despite the limited liability and other advantages which might be gained through incorporation.

However, once a sole proprietorship or partnership becomes profitable, both the "small business deduction" and the possibility for tax deferral described above provide an incentive for the business to be incorporated. The "small business deduction" is not available to sole proprietorships, partnerships or trusts. However, in contrast to these tax advantages of using a corporation, a sole proprietorship, as well as a partnership and trust, avoids a number of taxes which are levied on corporations, such as the federal large corporations tax and Ontario capital tax.

Although both general and limited partnerships have "flow-through" advantages to the partners, a limited partner is allowed to deduct his share of eligible expenses only up to his "at risk amount" invested in the limited partnership, as discussed in greater detail above.

Both partnerships and trusts might be preferred over corporations as business vehicles because they both provide income "flow-through" tax treatment to their partners and beneficiaries, as opposed to corporations which don't provide such treatment to their shareholders. But there is a significant difference between partnerships and trusts. Partnership income, although calculated at the partnership level, is taxed in the hands of the partners regardless of whether the income of the partnership is paid to the partners or not. Trust income, however, while calculated at the trust level, is only taxed in the hands of the beneficiaries to the extent that such income is paid to the beneficiaries, and is otherwise taxed as income of the trust.

When comparing partnerships with co-ownerships, partnerships, unlike co-ownerships, are recognized for the purposes of calculating taxable income. Therefore, capital cost allowance is determined at the partnership level for partnerships, whereas it is determined at the co-owner level for co-ownerships. If the co-owners wish to claim capital cost allowance on the co-owned property at different times or at different rates from each other, they are able to do so. Partners, however, don't have the same flexibility when it comes to partnership property, and therefore the partners must agree amongst themselves how much capital cost allowance they want the partnership to claim in any given year. Partners with other income in a given year are likely to argue in favour of claiming the maximum capital cost allowance available in that year, whereas partners with other losses in the same year are likely to argue in favour of no claim being made.

Summary

Although the tax advantages of a particular business vehicle often explain why that vehicle is selected over other possible vehicles, there can always be something else which pushes a business owner to select another vehicle which is not the most tax advantageous. He will simply ignore the tax implications to achieve what he really wants or avoid what he really fears.

For an owner who fears exposing his personal assets to the potential claims of business creditors more than anything else, he will choose a corporation. For an owner who insists that he must carry on business using a particular name even though that name is too similar to other existing corporate names, and refuses to use a corporation with a numbered name, he will choose a sole proprietorship instead.

For an owner whose main goal is to split any income of the business amongst the members of his family but doesn't want them to be employees of the business, he will decide to use a corporation. For an owner who insists that the employees of the business have an ownership stake in the business, he will select a corporation in order to issue options to them so that they may acquire shares. For an owner who wants to have some influence in the running of the business but who may not be contributing enough capital to be anything other than a minority shareholder if the business were incorporated, he will insist that the business be a general partnership and that he be made a general partner.

In other words, selecting a particular business vehicle because it affords the best tax treatment may fail to achieve the owner's main objective or address his biggest fear. The tax "tail" should therefore not wag the "business" dog. Despite the overall importance of tax factors when deciding which vehicle to use, they are nonetheless just a few of the many things to be considered when finally deciding upon the right vehicle for carrying on a business.

¹ R.S.C. 1985, c. C-44
² See generally Joint Ventures: Legal and Business Perspectives, Barry Reiter and Melanie Shishler (Toronto: Irwin Law, 1999)
³ Municipal Act, S.O. 2001, c.25
⁴ Real Estate and Business Brokers Act, 2002, S.O. 2002, c.30
⁵ Motor Vehicle Transport Act, 1987, R.S.C. 1985, c. 29 (3rd Supp.)
⁶ R.S.O. 1990, c.B-17, section 2
⁷ Ibid. at s. 7
⁸ Ibid. at s. 6
⁹ Business Corporations Act, R.S.O. 1990, c. B.16 at s. 10
¹⁰ R.S.O. 1990, c.E.27
¹¹ Income Tax Act R.S.C. 1985, c. 1 (5th Supp.) at s. 111 (1)
¹² Ibid. at s. 110.6
¹³ See generally Rules of Civil Procedure, R.R.O. 1990, Reg. 194
¹⁴ R.S.O. 1990, c.P.5
¹⁵ Ibid. at s. 2
¹⁶ Ibid. at s. 3
¹⁷ Ibid. at s. 10
¹⁸ Ibid. at s. 6
¹⁹ Supra note 6 at s. 2
²⁰ Ibid. at s. 7
²¹ Supra note 14 at s. 20
²² Ibid. at s. 46
²³ R.S.O. 1990, c. L.16
²⁴ Ibid. at s. 2(2)
²⁵ Ibid. at s. 5
²⁶ Ibid. at s. 33
²⁷ Ibid. at s. 3
²⁸ Ibid. at s. 6
²⁹ Ibid. at s. 23
³⁰ Ibid. at s. 21
³¹ Ibid. at s. 7(1)
³² Ibid. at s. 12(1)
³³ Ibid. at ss. 9 and 13
³⁴ Ibid. at ss. 10 and 44.1 to 44.4
³⁵ Supra note 11 at s. 96 (2.2)
³⁶ Ibid. at ss. 97 and 98
³⁷ R.S.O. 1990, c. P.4
³⁸ Supra note 11 at s. 20 (1)(a)
³⁹ Trustee Act, R.S.O. 1990, c. T. 23 at s. 9
⁴⁰ Ibid. at s. 27
⁴¹ R.S.O. 1990, c. S. 5
⁴² Trust Beneficiaries' Liability Act, 2004 S.O. 2004, c. 29, Sched A. at s. 1
⁴³ Waters' Law of Trusts in Canada, 3rd edition., Donovan Waters (ed.) (Toronto: Carswell, 2005), at 53
⁴⁴ Supra note 11 at s. 132.11 (1)(c)
⁴⁵ Ibid. at s. 111 (1)
⁴⁶ Ibid. at s. 132(6)
⁴⁷ Ibid. at s. 104(4)
⁴⁸ Supra note 9 at s. 92 (1) and note 1 at s. 45 (1)
⁴⁹ Supra note 9 at s. 34 (5) and note 1 at s. 38 (4)
⁵⁰ Supra note 9 at s. 243 and note 1 at s. 226
⁵¹ Supra note 9 at s. 15 and note 1 at s. 15
⁵² Supra note 9 at s. 9 (1) and note 1 at s. 12 (1)
⁵³ Supra note 9 at s. 118(3)
⁵⁴ Supra note 1 at s. 105(3), provided that a majority is required for corporations in those business sectors prescribed in section 16 of the Canada Business Corporations Regulations, 2001
⁵⁵ Ibid. at s. 149
⁵⁶ Supra note 9 at s. 3
⁵⁷ Ibid. at s. 3.4
⁵⁸ Ibid. at s. 3.2
⁵⁹ R.S.N.S. 1989, c.81, as amended
⁶⁰ R.S.A. 2000, c. B-9, as amended
⁶¹ Supra note 59 at s. 135
⁶² Supra note 60 at s. 15.2
⁶³ Ibid. at s. 105 (3)
⁶⁴ Ibid. at s. 119
⁶⁵ Ibid. at s. 118 (3)
⁶⁶ Ibid. at s. 124
⁶⁷ Ibid. at s. 146
⁶⁸ Ibid. at ss. 15.5 and 15.6
⁶⁹ Instead of incorporating in a jurisdiction which does not have director residency requirements, nominee directors meeting the Business Corporations Act (Ontario) or Canada Business Corporations Act residency requirements might be selected provided that their duties are shifted to the shareholders pursuant to a unanimous shareholder agreement
⁷⁰ Supra note 11 at s. 248 (1)
⁷¹ Ibid. at ss. 112(2.1) to (2.9), and Part IV.I and VI.1 dealing with preferred shares
⁷² Ibid. at s. 125 (7)
⁷³ Ibid. at ss. 85 to 88
⁷⁴ Ibid. at s. 110.6
⁷⁵ Simplification of Entity Classification Rules, Department of the Treasury, Internal Revenue Service, 26 CFR Parts 1, 301, and 602 RIN 1545-AT91
⁷⁶ Supra note 11 at ss. 2(3) and 115(1)
⁷⁷ Ibid. at Part XIV
⁷⁸ For example, registration of a sole proprietorship or partnership costs $80 under the Business Names Act, compared with $360 to incorporate under the Business Corporations Act (Ontario)
⁷⁹ Supra note 9 at Parts XI and XII
⁸⁰ Supra note 11 at s. 103
⁸¹ Ibid. at s. 7
⁸² Supra note 14 at s. 29(1)
⁸³ Ibid. at s. 30
⁸⁴ Supra note 23 at s. 12(1)
⁸⁵ Supra note 11 at s. 18
⁸⁶ Supra note 9 at Part VI

BACK TO ARTICLES INDEX