Sunday, December 11, 2011

Structuring Your Business

There are 3 traditional ways to operate a business in Canada;

i) a sole proprietorship
ii) a partnership
iii) a corporation

I’ve alluded to incorporating in my past but not provided any basic information. While there isn’t much in the way of unconventional wisdom in this post, I have found new entrepreneurs approach this whole discussion with fear & trepidation. I hope the following discussion will assuage those apprehensions. It really isn’t a big deal and no matter what you do you can’t cause irreparable damage with your choices

Technically as soon as you sell something, you are in business. This is a sole proprietorship and any profit you make is reported on your personal income tax return. The degree to which you grow from that point is just a measure of desire. You can stay at that level if you want. Of course CRA doesn’t spend too much time chasing people who have a garage sale or somebody selling quilts & crafts to friends. In fact, if your revenue is under $30,000 they don’t even expect you to charge GST. To be blunt, you’d be considered a nuisance more than a source of tax revenue.

Since you report any income from a sole proprietorship on your personal tax return there are two impacts, one is bad and the other is good.

Firstly, the bad one; your profits will be taxed at personal tax rates. For those who haven’t been paying attention to my previous posts, the reason it is bad is because governments charge much higher taxes to individuals than to businesses (but that’s another post).

The second impact is the good one. As a sole proprietor you are still considered in business so you will be recording all your business related expenses and deducting from your business income just like any other incorporated or partnership business.

The sweet spot is that if your business expenses exceed your business income in any given year you are allowed to deduct those leftover business losses from income on your personal tax return, specifically employment income! In other words CRA allows people to “grow” into their business as a part-time activity while still maintaining their regular 9-to-5 job. I recommend this option as a risk mitigation strategy.

The survival statistics on start-up businesses are not good. It can take a number of years of investing in these losses before a business can have all the pieces working well to make it successful. So CRA views this allowable support for a few years as a smart thing to help you out. Of course, don’t expect to run up continual losses over many years without any taxable profit. CRA is not that stupid.

To operate a simple part-time service as a sole proprietor doesn’t require much at all. You may need to get a municipal licence, or other certificates & approvals depending on your line of business. These may include registering physical store-front premises, parking, health & safety, employees and other considerations.

The one thing I recommend from Day 1 for any size business is to out-source your accounting and taxes to a good bookkeeper and/or accountant.

I won’t dwell on partnerships much. In some respects they are taking the limitations of a sole proprietorship and layering on the complexities of multiple decision makers. Many entrepreneurs often get started with peers and associates. Teamwork & collaboration is instrumental in building a successful business. However, I just think a partnership requires more skill and leadership to manage than a corporation. Many inexperienced entrepreneurs are intimidated by the concept of incorporating and feel a partnership is “simpler & easier”. I’ve seen many potentially good businesses flounder because the owners are spending so much time on the politics & stress surrounding management of the partnership instead of applying their efforts to decisive, proactive leadership in the business. I suggest you avoid the aggravation and start your venture yourself. If you need certain skills you can initially bring in those same people as vendors & suppliers to your business. Gain some leadership and business management skills first. Allow yourself the opportunity to see how things perform in an entrepreneurial environment before you hand over the keys. You can always invite additional people to join you as an equal or subordinate peer later. I would add a special caveat to family members and spouses. The stress of managing a business together can sometimes ruin good family or marital relationships.

Once you have a good understanding of business and acquired solid leadership skills there are some benefits of partnerships that are worth investigating, but for new entrepreneurs I recommend you start your journey with either of the simpler options; the sole proprietorship or the corporation.

Don’t let the word, the concept or your own fears prevent you from considering this. Once you start to seriously grow your business; once you are beyond being a dabbler for beer money; once you think you need help to keep up with sales; once you leave your employment position to work full time on your fortune; you should incorporate! In my opinion the benefits far outweigh the drawbacks. I prefer to discuss the drawbacks in worst case scenario; in other words; “Why wouldn’t you incorporate?”

The costs - this is often trotted out as a good reason not to incorporate. The truth is you can incorporate anywhere in Canada for $500 or so. There is a myriad of online services, including the federal government’s own website that can set you up as a corporation in hours or even minutes. The annual fee to keep them going is in the neighbourhood of $25 a year to file a piece of paper. So if your whole business venture is a flop, you are out-of-pocket $500. That is a throw-away cost. I would guess you probably burn that much running your car for a month. If anybody can afford to incorporate, then it isn’t much of a downside risk. What else could it be?

The financial record keeping - In my opinion anyone in business (excepting perhaps the handmade crafts people) have to pay taxes whether you’re incorporated or not. Anyone who has looked at paying taxes knows good financial record-keeping is essential to minimize tax. So whether you’re incorporated or not you should still have a bookkeeper and/or accountant handle that part for you. So paying an accountant to reduce your taxes is the same whether you are a sole proprietor or a corporation; that can’t be the reason.

The extra legal paperwork & administration – To keep your corporation running, the government only wants three things; i) you must pay your taxes ii) you must file your tax returns so they can confirm you are paying your taxes and finally iii) a piece of paper (& fee of course) that provides contact information in case they want to chase you for not paying your taxes! Do you see the common theme? Your accountant will look after i) and ii) leaving you with iii). You’ll spend longer waiting in your dentist’s office every year than filling out that form and mailing it with a cheque. The incorporation service or lawyer you selected for getting the corporation set up will have probably given (or charged ) you a little binder. It contains all the legal & administrative paperwork. In most cases, it is put in a drawer that day and will never again see the light of day. In theory, you are supposed to hold a meeting with yourself once a year and write some things down (meeting minutes and resolutions etc). In all practicality, I can’t think of anyone who would want to review those meeting minutes. My suspicion is you will go to your grave with that binder still in the drawer. The only exception will be those partnerships where one partner or spouse is suing the other for breach of their partnership agreements. In those cases you need to have all these documents formally kept up to date… primary proof that partnerships are more complicated than corporations!

The benefits of incorporation are numerous. The primary benefit is the provision of specific legal protection from liability. Corporations live forever; so if your business holds assets in United States, you will simplify the issue of US estate taxes. Corporations allow you to income split between family members who are shareholders; significantly reducing taxes. Corporations allow you to determine specific dates for payment of income to yourself to further reduce taxes. In my PHSP business alone, a corporation has unlimited room for eligible deductions whereas sole proprietorships have CRA-specified limits. In 2011 that limit is $1500 per adult.

And as for closing corporations down, you just have to ensure you’ve paid your last taxes and let them die. You can file paperwork and pay a fee to have them dissolved, or if you don’t file the paperwork for a period of time, they are simply placed on the defunct list. Done!

I have opened and closed dozens of corporations in my little empire. They are cheap, fast and easy to utilize. I don’t see any significant risk in a worst case scenario and they have significant upside.

Of course, when you are setting up your business you should talk to a credentialled expert in this field. My unconventional wisdom suggestions fit my risk profile but may not fit yours.

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