Proprietorship, partnership or corporation: Do you know the implications of your business structure?

You thought you set up your company in a way that protects you from being held personally responsible for business debts. So why is the Canada Revenue Agency (“CRA”) and other business creditors going after your personal assets to cover the company’s outstanding debts?

The answer lies in your business structure as well as certain partnership or creditor agreements you may have put in place. This is why it’s important to understand the different business structures and how they could affect your personal assets. It’s especially important to know where you stand if you’re facing a small business bankruptcy or a Division 1 proposal.

Understanding business structures: Back to basics

There are three main categories of businesses in Canada: a corporation or incorporated company, sole proprietorship and partnership. Here’s an overview of these three structures:

• A corporation or incorporated company is owned by shareholders, each of whom is a separate legal entity from the company. A corporation is required to file its own tax return.
• A sole proprietorship is owned and operated by an individual, who is not considered a separate legal entity from the business. This individual – the sole proprietor – is required by CRA to include the company’s profits and losses when filing personal income tax returns.
• A partnership is similar to a sole proprietorship but is owned by two or more people, who are known legally as partners. The partnership does not file a tax return. Each partner includes its share of the partnership income or loss on their personal tax return. The amount claimed depends on the percentage of ownership held by each partner.

So what are your personal liabilities within each structure?

If you’re a sole proprietor or a partner, then you bear personal responsibility for the debts incurred by your business. In a partnership, the amount of the business debt that you’re liable for depends on your ownership share of the business. For example, if you own half of the business, then you’re personally responsible for half of the debt.

In a sole proprietorship or partnership, personal debt incurred by an owner or partner could also be claimed against the assets of the business. In these cases, the business’s creditors have right of way over personal creditors, who can only take what’s left after the business has paid its debts.

For incorporated businesses, the general rule is that shareholders and directors are not personally liable for the company’s debts.

Fine print: What else you need to know about your liability for business debt

How these general rules are applied in real-world situations isn’t always simple or straightforward. If your partnership or corporation owes taxes, it may not matter in the short-term that you own only a small percentage of the company. The CRA could decide to go after you for the entire amount owing and leave it to you to collect from your partners, or other directors.

With an incorporated company, directors and shareholders who provide a personal guarantee to a creditor become personally liable for the debt they’re guaranteeing. Consider this carefully before consenting to provide a personal guarantee for a loan or for a lease.

Keep in mind as well that directors of an incorporated business are personally liable for unpaid wages, vacation pay, employee source deductions for such items as Canada Pension Plan, Employment Insurance, Income Tax deducted from their employees pay and not remitted and for sales taxes (HST, GST or PST).

Protecting yourself should the business run into financial difficulties

It may be impossible to plan for every contingency in business, but you can take steps to reduce your personal risks as an entrepreneur. For example, when asked to personally guarantee a bank loan or a lease for equipment or office premises, try to negotiate certain terms of the guarantee, such as reducing the number of years the guarantee covers or capping the amount of the guarantee.

You may also want to push back if a creditor asks that your spouse or partner step in as an additional guarantor. This way you can at least protect your spouse or partner’s personal assets should your business find itself in financial trouble. In case you’re worried about not being in a position to negotiate, remember that lenders are all competing for market share and some may be willing to make concessions to win your business.

Seek professional help before you make important business decisions

Whether you’re just about to start a business or are in the mature stages of an enterprise, it’s important to get help and advice from the right professional. A business strategy consultant can provide guidance on how to best structure your company and could advise you on negotiating loans and lease agreements.

If your business is struggling financially, it’s critical that you seek the expertise of professionals such as a Licensed Insolvency Trustee. A professional can help you understand your obligations and rights within your business structure, and work with you to create a plan of action. Depending on your circumstances, this plan could include corporate restructuring, refinancing, filing a Division 1 proposal or a corporate bankruptcy.

Think you need professional advice? There is no time like the present

Financial problems have a way of getting worse when you don’t address them. If your business is struggling with debt—whether you’re a sole proprietor, a partner in a partnership or a director of a corporation—the best thing you can do is seek professional help as soon as possible.

Knowing the nuances of your business structure, taking steps to protect yourself and being proactive will enable you to be in better control of the situation when financial problems happen.