There are many questions for a founder to think through when starting a business, and a preliminary legal one is what type of entity should the business be operated under. This choice matters not only for formality reasons, but also for the tangible and substantial legal consequences associated. Understanding the nuances and choosing the right entity goes long for a business. This article will explore some of the most salient differences between a sole proprietorship and a corporation.
The most distinguishing feature of corporation is its status as a separate entity. The legal system treats a corporated company as an independent virtual person that is separated from its owners, even though the owners may regularly control the operation of the company. The corporated company, as a virtual person, replaces the owners as the direct recipient of all results that the company generates, such as legal liabilities, debts, and profits.1 Owners's exposure to such results become secondary and limited - owners do not receive any of the results unless the corporated company decides to pass any on to the owners, or in certain bad faith operation cases which will be discussed in a future article.
On the other hand, the legal system sees a sole proprietorship and its owner as one integrated being. The sole proprietorship is part of its owner, and the owner's personal realm includes the sole proprietorship. (Note, a sole proprietorship can only have one owner. If there is more than one owner, the sole proprietorship can potentially become a partnership.2) Thus, the owner of a sole proprietorship remains as the direct and unlimited recipient of the business's results.
The significance of being the direct recipient of business results is the associated responsibility - the direct recipient of results should be responsible for such results. For a sole proprietorship, the owner is the direct recipient of all business results, therefore the owner is responsible for all legal and financial liabilities that arise from the operation of the business. For a corporation, to the contrary, the corporated company is the direct recipient and it absorbs the majority responsibility arising from its own operations, and the owners' exposure to such responsibility becomes second-handed and veiled. If a party does not have responsibility, the party cannot be sued for any failure to comply with that responsibility. That means, if a sole proprietorship generates any debt that it is unable to pay, the creditor can go after the owner personally, requesting the owner to pay out of his personal pocket; but if a corporation owes an outstanding debt, the creditor can only go after the assets of the corporated company, and has no recourse against the owners personally. Similarly, if a sole proprietorship breaches a contract or commits a tort, the claimant may sue the sole proprietorship's owner personally; but if it were a corporation, the claimant would only be able to sue the corporated company and not the owners in personal capacities.
Nevertheless, being the direct recipient is preferable when it comes to profits and taxes. Since the law does not distinguish a sole proprietorship and its owner, the financial statements of the two are combined. Profits of the business go directly into the pocket of the owner, and is taxed together with all other income of the owner's. That means, for a sole proprietorship, the business profits are taxed only once before the owner receives them. On the other hand, profits of a corporation are taxed twice before owners of the corporation receive them. When a corporation generates a profit, the profit is first deposited into the accounts of the corporated company, which is managed separately from the personal accounts of the owners. The corporated company is required to pay taxes on all income it receives on its own account, so when the profit is deposited into the corporated company's account, it is taxed once. When the corporation decides to distribute profits to its owners, into the owners' personal accounts, guess what happens? It gets taxed again! So, by the time the owners of a corporation receive the profits, the profits have been taxed twice.
There are other mechanical differences between the two forms of business entity, such as rules on formality of operation, registration process and naming. These will be discussed in future articles. Overall, sole proprietorship functions like a nimble boat, providing its owner with a light and convenient vehicle that is easy and cheap to operate, but offers little protection from the unknownable risks of the ocean. Corporation, in contrast, resembles a heavy ship that well protects its owners from the turbulence of the ocean, but is much more expensive and complicated to rein.
1 Business Corporation Act, R.S.O. 1990, c. B.16, s.92(1).
2 Partnership Act, R.S.O. 1990, c. P.5, s.2.
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