Let’s start with a hypothetical example, undertaken by our Hypothetical Client:
Archibald Reginald Wilkins, the third; or “Bob”, to his friends.
Bob decides he wants to start a business going door-to-door selling two things: Lemon-Lime Flavoured Soda, and Lemon-Lime Flavoured Laxative. To save costs on bottling and labeling, he elects to use the same type of can, and general form of label on both the laxative and soda; but because he is not a fool, he places a sticker with words “Not Laxative” on the bottom of the soda cans.
Now, Bob wants to have his profits under “Bob’s Soda and Laxative” taxed separately from his day-to-day income. He also recognizes that it is possible that his business might get sued, but he thinks the most likely culprit is the pro-constipation activists in his city. So, Bob pops down to his local registries office, pays them and receives 5 pieces of paper, the first of which proclaims the creation of “Bob’s Sales Inc.”. With this in hand, Bob places 12 cases of soda and 12 cases of laxative in his wagon, and he starts knocking on doors to sell soda and laxatives.
Unfortunately, Bob failed to realize that although he was a shareholder of Bob’s Sales Inc. and therefore isolated from the liabilities of the company, he was also the sole director, officer and maybe even agent of Bob’s Sales Inc. While he is not liable as a shareholder, he is entirely liable as the director of a company engaging in a risky behavior, and as officer of the company he may be carelessly supervising the application of the “Not Laxative” label at the warehouse, and as an agent, he may be negligently selecting and passing on the wrong cans to his customer. When a customer’s “Anniversary Balloon Ride” goes tragically wrong following a celebratory soda at 1,500 feet; Bob’s Sales Inc. is certainly a target for a lawsuit, but so is Bob, not as a shareholder, but as the director, officer and agent of the company.
Bob obtains the benefit of separate taxation of Bob’s Sale Inc., but that might not be a benefit. If Bob’s Sales Inc. realizes substantial losses year-over-year, then it is not possible to use those losses to offset his individual income, as “Bob” the Individual is taxed separately from the company (I have heard the cool kids refer to this as having “trapped losses”). If Bob would have operated his soda and laxative sales as an individual (sometimes called a sole proprietorship) he could have offset his losses in the sales business against his employment income. Further, Bob doesn’t necessarily obtain the benefit of isolating his assets as an individual against lawsuits against the company; as he was the sole director, officer and agent of the company. Finally, when Bob tries to get any loans from Bob’s Sales Inc. (even a credit card) every bank insists that Bob, as an individual, guarantee the debts of the company; so Bob is essentially borrowing the money of the corporation against his own credit and assets.
So this provides some elements of how a corporation might not be of use to Bob, but lets look at some reasons why a corporation might be of benefit to Bob.
Let’s consider what happens when Bob wants to finance the business not through loans, but rather by offering up a portion of the profits in exchange for money (which is not a decision to be taken lightly, as there are significant laws and regulations that govern this, all related to issue of a security). How can Bob go about this?
Bob could enter into a contract with the lender, the terms of which provide the lender to receive repayments of the loaned amount along with a pre-determined percentage of the profits, and if Bob’s business fails, they would receive the assets used in the business as repayment towards the loan. Its even possible that if the loan is large enough, the lender would like to have a voice in the operation of the business. This can all be provided under a contract between Bob and the Lender.
But, if we remember back, in Part 1, the rights of shareholders capture many of those key elements, and prevent us from having to spend thousands of words in a contract to capture those elements. Bob can create a corporation and provide for classes of shares that allow sharing of the profits of the corporation, receipt of the assets of the corporation in case it winds down or closes, and even a voice with respect to the operation of the corporation through a vote at Shareholders meetings. We can even tweak the documents that describe the corporation and its structure (called the “Articles” of a corporation) to allow for the lender to get preferential treatment when it comes to a receipt of the profits, or distribution of the assets on wind-up.
The use of a corporation provides a robust toolbox for Bob to include others in his business, in this case a lender can become an investor; and incorporation may simplify that process. Further, since corporations can hold property, the investor has more certainty as to what assets are part of the business (being those owned by the corporation) versus that property owned by Bob.
The ability to use shares to distribute the profits of the corporation, also provides an additional tool for Bob to use, for example if Bob had a dependent, or a life-partner that he wanted to distribute some of the proceeds to. This can be particularly attractive when profits increase with Bob’s business, since in Canada we have tax rates that change as your revenues increase; with Federal tax of 15% paid on the lowest tax bracket ($47,630.00 as of 2019) and 33% paid in the highest tax bracket (over $200,000 as of 2019). If Bob had $300,000.00 of profits to distribute in the year, he might have an advantage of receiving $150,000.00 himself, and then having $150,000.00 received by his life-partner.
Incorporating does have its uses, even if you are operating a “one-person show”: the inherent structure of a corporation provides alternatives to raising capital for your business venture, a way to distribute the profits of the venture, as well as some protection against liabilities incurred by your business.
In the end, the question of whether you should be using a company structure for your business comes down to the specifics of what you do, how you plan on doing it, and where you want to go with what you are doing. But, I hope the preceding provided some background to help you frame the questions you need to consider.
If you want more information, or want to discuss how we can help you with your business needs, feel free to Contact Us.
– Craig K. Sherburne
Content is not intended as a legal opinion; and readers are cautioned not to act on the information provided without seeking legal advice on their unique circumstances.