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Forming your start-up: Options for business entities in Canada

start-upThere are a variety of business organizations that can be used to operate your tech start-up in Canada. Although many businesses are operated through a corporation, it is important to understand other forms of business organizations. As there are significant tax, legal, financial and practical implications, selecting the right business organization for optimizing your business’s chance for success. The following are three of the most commonly utilized business organizational structures for a start-up business in Canada.

1. Sole proprietorship

A business owned and operated by one person without a form of business organization, such as a corporation or partnership, is a sole proprietorship. Although the business may have a trade name, it is not a separate legal entity. The benefits of a sole proprietorship include low start-up costs and certain tax benefits, such as possible deductions against other sources of personal income.

One of the disadvantages of a sole proprietorship is that the proprietor is personally responsible for the liabilities and obligations of the business. For example, if the business is unable to pay its debts, the creditors will pursue the proprietor personally for payment. Another disadvantage is difficulty in attracting investment, because the proprietor cannot issue equity securities but can only seek debt financing. In addition, a sole proprietorship does not provide much flexibility in terms of tax planning. Sole proprietorships often make sense for a one person, early-stage, bootstrapped business focusing on product or sales development. Sole proprietorships are not appropriate when there is more than one founder.

2. Partnership

Unlike a corporation, a partnership is not a separate legal entity, but a relationship that exists between two or more parties who carry on business in common with a view to profit. Partners may be people, corporations or even other partnerships. Partners share in the profits and losses and net proceeds on dissolution. The most significant advantage of a partnership is that a partnership is permitted to “flow through” losses to its partners that may, subject to certain rules in the Income Tax Act (Canada), be used as deductions against the partners’ other income. For start-ups that anticipate initial losses, partnerships can be helpful to reduce the amount of income tax the partners may pay. In addition, in order to raise money, partnerships can seek debt financing, but can also issue partnership units to partners.

A significant disadvantage of a partnership is that each of the partners is personally responsible for the liabilities of the partnership, and each partner’s personal assets are exposed in the event the partnership assets are insufficient to cover such liabilities. A partner’s liability can limited through the use of a limited partnership rather than a general partnership. In a limited partnership, a limited partner is only liable to the extent of its investment in the limited partnership, so long as the limited partner takes a passive role in the business and governance of the limited partnership.

3. Corporation

As it becomes clear that your tech start-up is a viable business, it is often advisable to incorporate. The timing and process of incorporation should be made in consultation with your legal, tax and other professional advisors to maximize tax benefits and minimize costs. Unlike the other forms of business entities discussed above, a corporation is a separate legal entity from its owners. The shareholders do not own the property of the corporation, and the rights and liabilities of the corporation are not those of the shareholders. The liability of the shareholders is generally limited to the value of the assets or funds they have invested in the corporation to acquire their shareholdings. In addition to the advantages of limited liability, the securities of a corporation are generally more readily marketable. As a result, potential investors often view equity securities (such as shares) or other debt instruments of a corporation as more attractive investments than partnership units. In some situations, there may also be tax advantages to using a corporation.

How do I incorporate?

A corporation is created by filing the required incorporating documents (e.g., articles of incorporation) with the appropriate government agency. If you are specifying a name for your corporation, rather than using a numbered company (i.e. 1234567 Alberta Ltd.), a name search result called a NUANS search is required in the jurisdiction you intend to incorporate. Once successfully filed, you will receive a certificate of incorporation.

While incorporation may be done at a corporate registry, we recommend that you obtain legal advice prior to incorporating as there are certain potentially significant nuances relating to securities laws that are affected by the articles of incorporation.

Federal or provincial incorporation?

A corporation may be incorporated provincially or federally. There are several factors that determine what jurisdiction you should incorporate in, such as physical location, where your business intends to operate, the nature of the business and additional registration fees. For example, if your start-up is in the fintech space, it may fall under the definition of “banking” and be required to incorporate federally. Another often unforeseen cost associated is extra-provincial registration, which is required if you are conducting business in a province other than the jurisdiction of incorporation. For example, if you incorporate in Ontario and want to conduct business in Saskatchewan, you may have to pay an additional fee to register the corporation in Saskatchewan.

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McCarthy Tétrault LLP

McCarthy Tétrault is a Canadian law firm that delivers integrated business law, litigation services, tax law, real property law, labour and employment law nationally and globally.McCarthy publishes a series of blogs to share information with companies to help them comply and manage their businesses. On the Inside Internal Controls blog we will share some of those blog posts sharing their expertise among others, in the areas of Competition/Anti-trust, Corporate and Commercial Law, Intellectual Property, Privacy, Environmental Law, Technology and Litigation. Read more
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