Sole Proprietorships vs Corporations
I am going to approach this topic at a high level, since the corporate structures and tax saving vehicles available to you will vary depending on what country you live in. For example, I live in Canada, so I operate my business through a Canadian corporation. If I lived in the US, I would likely have opted to operate through what they call a Limited Liability Company (LLC). Similarly, if you live outside of North America, there are likely other forms of corporate entities that may be more beneficial to your specific circumstances.
With all that said, we can approach the topic of corporate structure from a high level that will be applicable to nearly everyone, no matter which country you call home. In this section we will evaluate the general differences between sole proprietorships and corporations, as it’s an important topic to familiarize yourself with when starting a business.
Sole proprietorships and corporations are simply different legal structures that you can choose to run your business under.
Sole Proprietorships
A sole proprietorship is the more simple of the two. If you dropped this book right now, went outside, purchased a small property in your town, set up a little gift shop and started selling trinkets to passing by visitors than you would be operating your business as a sole proprietor. There is little to no set-up work required to start a business under this structure.
Any expenses you incur or revenue you bring in from operating as a sole proprietor will be attributed to you on a personal level. That means, if your sole proprietorship business makes 20k in profit for the year, then you will pay personal income taxes on that 20k of profit on your personal income tax return. Similarly, let’s say you make 20k from your sole-proprietorship business while working your full time job as a nurse making 60k. Now your personal income for the year will be 80k and you will pay personal income taxes on all of it.
To sum up, sole proprietorships are merely an extension of yourself. There is no legal distinction between you and your business. And any income/losses you have through your business will all show up on your personal tax return. Similarly, if your business gets into any legal trouble (such as getting sued for selling a dangerous product), then you are personally liable for all actions of your business.
Corporations/LLCs
Corporations are an entity that is legally separated from its owners and shareholders. This is an important point to drive home, and is a principle difference between conducting business as a sole proprietor versus a corporation.
In the US you can also choose to operate under an LLC (Limited Liability Company). This is slightly different than a corporation, where you can choose to be taxed either as a sole proprietor or a corporation. For this article I will treat US LLCs as another form/alternative to corporations.
Let’s look at one example to drive home the key difference between sole proprietorships and corporations. Let’s say James wants a start an e-commerce business and incorporates a company called James Commerce Inc. James is the only person starting the business with no other partners so he owns 100% of the company. James and James Commerce Inc. are separate legal entities in the eyes of the your government. Come tax time James will file a personal return for his personal income and expenses, and his corporation will file a corporate tax return for its income and expenses. In other words, a corporation is a creature of law. It is the creation of an artificial person so to speak (the artificial person being your new business entity).
Continuing with the example above, all transactions between James and James Commerce Inc. need to be meticulously tracked and taxed. So, if James Commerce sold $10,000 in products online, James cannot simply stick his hands into the James Commerce Inc. corporate bank account and put that money into his personal bank account. This would be the same as you putting your hands into your neighbors bank account, it is not technically your money. Instead, you need to withdraw payments from the corporation into your personal accounts, and there are tax implications for doing so.
Since income for your corporation will not automatically show up on your personal tax return, and you can choose how and when to take that money out of your company, there is a big opportunity to get creative here with tax strategy. Without getting too into the nuts and bolts, you can essentially decide when you take money out of your corporation so you strategically defer taxes to years you are in lower tax brackets. This is one of the great benefits of operating under a corporation.
Another big benefit of a corporation is the limited liability that comes with it. Since a corporation is a separate legal entity in the eyes of the law, that means if someone sues your company then you will not be personally liable (most of the time). In other words, if someone sues your company than they cannot come after your personal bank accounts, car, or house in the lawsuit.
Let’s put this into an example for illustration. If James makes an honest attempt with his e-commerce business, but after 2 years the business goes bankrupt, then the company’s doing business with James Commerce Inc. cannot go after James personal assets to cover his businesses’ debt (unless James backed his businesses’ debts personally, which can often be demanded by Banks in the case of small start-ups).
The corporate veil of a corporation is solid, and can only really be broken in the case of mal-practice, or if you knowingly break the law through the actions of your company. For example, if James raised investment capital for his e-commerce business, but then took all that money and played blackjack with in it Vegas than this would be considered mal-practice, fraud or a sham, and James would be personally liable for the debts of his company.
Another common example of fraud that occurs is if James decides he does not want to pay his corporate taxes for his company. In this case the governing tax body of his country could go after his personal assets to cover his tax liability. But keep in mind that if the government pierces the corporate veil to sieze over due tax money, that does not necessarily open the corporate veil to everything. The corporate veil will still hold up in the situation of a customer suing your company for example, even if it was pierced to collect on overdue tax moneys. This is the case in Canada at least, but like I said earlier, it may vary depending on your location.
One final way that James personal assets could be at risk is if James made a personal guarantee on his corporation’s loans. For example, if James wants a bank loan for his business the bank may require James to back up the loan personally for his business, in which case he would be at risk.
Should You Incorporate?
So now you have an idea of what a corporation is, and the chief differences between a corporation and a sole proprietorship. But should you incorporate? And if so, when? That is what this chapter will aim to answer.
Benefits of a Sole Proprietorship
From my experience the biggest benefit of a sole properitorship is the shear easiness of starting one. You basically do not have to do anything, just go out there and start selling something and you will be a sole proprietor. God knows there are a million things to think about and a million doubts going through your mind when starting a new business. So the fact that sole propreitors are so quick and easy to start is great for most people. They are one less barrier to starting your new company you have been dreaming of.
Apart from just being easy to start, they are also free to start. Filing to start a corporation will cost you at least $500 in Canada, and that is if you do it yourself. You can easily be looking at $1,000 to start a corporation if you go to a large accounting firm. Money is tight when you are first starting a business, so this can be a big drawback.
Liability Considerations
Liability protection is a big consideration when deciding whether or not to incorporate. Incorporation provides liability insurance against our personal well-being. So if our business fails, or if someone sues us because our products were faulty, only our companies assets are at risk, and not our personal assets. Companies going after the operating corporation cannot pierce the corporate veil and go after the personal assets of the shareholders. This is the same way as if you held shares in Apple, and Apple sells a mac that blows up and kills everyone, you as the shareholder cannot be sued and your personal assets will not be at risk because you own shares in Apple.
So you are protected personally by your corporation under normal business activity. But now let’s talk about ways that the corporate veil can be broken. One way is if you are conducting fraudulent activity in your business venture. If you are found to be conducting illegal or partaking in fraudulent activities than that corporate veil can break down, and you can be held personally liable for your business.
A second, and more common way people can get in trouble is by agreeing to personal guarantees when they take loans or open accounts with their bank on behalf of their business. If this is the case and the business cannot pay back its loans to the bank then the bank can dig into your personal assets to cover the loss.
In my opinion liability protection is the biggest benefit there is in incorporating a business. It is the best thing you can do to reduce your personal risk when starting a business. Especially if your business sells or offers products/services that have a high chance for lawsuits or damages. For instance, if you are selling any products that are ingested or used on the skin then I would highly recommend incorporating to protect yourself against possible lawsuits in the future. You never know when someone can claim that your product harmed them.
Holding Companies
Holding companies are another interesting topic. They are essentially a second corporation that we can open to house our operating business. It’s a topic you do not really have to think about in the early stages of a business. But it’s good to know the basics.
Since corporations are treated as separate legal entities, they allow us to really get creative in terms of reducing our business risk. Let’s say James new e-commerce business did incredible and after 3 years had a bank account with over 1 million dollars in it. At this point, it could be in James’ best interest to reduce the risk that some disgruntled customer will sue him and go after all that money.
The best way to do this is for James’ to open up a second corporation, and transfer all that money he made in his operating company to this new company. A company started for this reason is typically known as a “holding company”. It is a company created to hold the money for one or more operating companies, to reduce the risk that someone can come after that money in a lawsuit.
There could also be tax advantages to a holding company. By lowering the amount of profits on the books for 1 company and sharing the profits with a holding company. Of course if you are at the point of considering a holding company, you likely have already have a rockstar accountant on your team to help with this.
Another question you are probably thinking is, will the money transferred between an operating company and a holding company be taxed. Thankfully, you can typically do this tax free in the form of dividend payments from your operating company to your holding company. Once you transfer your money to your holding company, you can loan that money back to the operating money to fund growth, giving that money some legal protection. But again, talk to your accountant about this stuff. As business owners we do not have to be experts when it comes to corporate structure. We just need to know enough to work with our accountants to minimize our liabilities the best we can.
Summary
So, in a nutshell, the two different corporate structures to start a business are under a sole proprietorship or corporation/LLC. Whichever you choose you must also maintain good accounting and bookkeeping practices into your business. Bookkeeping is the practice of constantly keeping track of every single transaction, sale or investment that your business makes. This is incredibly important for businesses as you need to know exactly how much money you have on hand, if you are making more money than you are spending, and what trends you are seeing in your profitability over time.
In order to do this effectively you must log all your transactions in an accounting software, excel sheet, or in physical books. I strongly recommend an accounting software, as this will drastically uncomplicate your life (as we will see later). But in summary you will have to maintain good bookkeeping and accounting practice whether you choose to operate under a sole proprietorship or corporation (there is no getting out of it).