One of the first legal decisions you'll make for your business is the legal structure. From being a sole proprietor to incorporating a company or forming an LLC (for U.S. businesses), your decision will impact your financial, tax, and legal obligations.
No pressure, right?
Should I Incorporate?
It’s no wonder that at least 60% of the time when clients book a consult with me through my law firm, their intake form looks something like this:
“I’ve been running my business for a while, and I’ve been thinking about incorporating. I’d love some advice on whether it the right time for me.”
This question pops up over and over again in entrepreneur circles—especially among those ready to take their business to the next level. While there’s no hard-and-fast rule that applies to everyone, it’s crucial to weigh the legal and financial implications of staying as a sole proprietor, incorporating your company, or if you’re in the USA, forming an LLC.
(Spoiler alert: we don’t have LLC’s in Canada, in case you were wondering!)
Let’s break it down, so you can make an informed decision about which structure is best for you.
How to Choose the Right Legal Structure for your Business
When you start your business, you might begin as a sole proprietor. Over time, however, you may outgrow this structure as your business evolves. There are pros and cons to each structure, and the right choice depends on your specific situation. In Canada and the U.S., the most common legal structures are:
Sole Proprietorship
A sole proprietorship is the most straightforward and common legal structure for small business owners who are just starting out. If you haven't taken any legal steps to start your business, surprise - you're operating a sole proprietorship!
In this structure, you and your business are legally the same person in the eyes of the law. While it’s easy to set up and maintain, there’s a significant downside: you're legally the same person as your business.
Here’s the key issue, as a sole proprietor you’re personally responsible for any business debts or legal actions taken against your business. If something goes wrong—say a client sues you or you can't pay a business debt—your personal assets, like your home or car, are at risk.
As a sole proprietor, all of your business income is also considered personal income, so there are no tax planning strategies or advantages.
For those running small businesses with minimal risk, like consultants, coaches, copywriters or graphic designers, and who aren't at a stage where they would benefit from more advanced tax planning, this structure can be totally fine. However, as your business grows, so do your risks, which makes incorporating a company or, if you're in the US, forming an LLC worth considering.
Partnership
A partnership is when two or more individuals go into business together with the goal of making a profit. There are different types of partnerships, such as general partnerships and limited partnerships, but in a general partnership (most common for entrepreneurs and online business owners), each partner shares responsibility for the business’s operations, profits, and liabilities.
While a partnership allows for the pooling of resources, skills, and responsibilities, there’s a major drawback: you are personally liable for any debts or legal issues your partner incurs, even if you had no direct involvement. So yes, you're personally on the hook (read: liable!) if your biz partner signs a really dumb contract or charges something to your business credit card you didn't agree to.
For those thinking about entering a partnership, it’s really important l to have a well-drafted partnership agreement outlining the terms of your partnership, including how profits are divided, the responsibilities of each partner, and what happens if one partner wants to leave the business.
Partnerships can work well when there’s a solid foundation of trust between partners, but it’s important to be mindful of the potential risks, especially from a liability standpoint. Think about it as a business marriage between you... and the best marriages are built on trust, shared values, goals and honest communication.
Incorporation
“Incorporating a company” means forming a separate legal person, legally speaking. Once you incorporate, your business becomes distinct from you personally, which provides you with "limited liability protection" which, in plain english, means liability relating to the business is limited to the assets of the company, and not the owners, personally. In most cases, if something goes wrong, only the assets of the corporation can be used to satisfy any debts or liabilities. This means your personal assets are usually protected.
Here are some reasons to consider incorporating your business
- Separate legal protection: Incorporating shields your personal assets from business-related risks. (There are exceptions this). For those in industries with higher legal risks, like gyms, daycares, or construction, incorporating early on can be an important consideration.
- Tax advantages: Corporations often have more tax benefits, like the ability to defer taxes and deduct more expenses.
- Credibility: Being a corporation can enhance your business's reputation, particularly when working with larger clients or securing funding.
- Growth and scaling: If you plan to bring on other owners, raise capital, or eventually sell your business, incorporation is often necessary.
- Limited name protection: This is usually imited to the jurisdiction where you incorporated. If you want to really protect your business name, you should trademark your name in the countries where you do business.
Incorporation also comes with its fair share of responsibilities—annual filings, separate corporate taxes, and adhering to corporate governance. There are also more upfront costs, including incorporation fees, and ongoing costs associated with separate tax filings for your company and annual filings.
For U.S. Businesses: LLCs (Limited Liability Companies)
If you’re based in the U.S., you have a middle-ground option: enter the Limited Liability Company (LLC). An LLC offers the liability protection of a corporation but with the **flexibility of a sole proprietorship**. Many entrepreneurs see it as the best of both worlds.
Why form an LLC?
- Liability protection: Like a corporation, your personal assets are separate from your business.
- Fewer formalities: You avoid the more stringent corporate requirements, such as having a board of directors or shareholders.
- Tax flexibility: LLCs have several tax options, including being taxed as a sole proprietor, partnership, or corporation, depending on what benefits you most.
For small and medium-sized business owners in the U.S., the LLC is often the go-to option because it simplifies many of the corporate obligations while still offering key legal protections.
When Should I Incorporate?
Now that you have a better understanding of your options, the question remains: When should I incorporate your business?
Contrary to what you might read in Facebook groups or hear from other entrepreneurs, there isn’t a magical revenue number when incorporation becomes necessary. For example, hitting six figures in revenue doesn’t necessarily mean it makes financial sense to incorporate—especially if it costs you $99,000 to run the business! From a tax perspective, it usually only makes sense to incorporate when you have profit that you want to keep in your bank account.
Things to consider before incorporating your business:
- Legal risk: If your business carries significant legal risks, such as client liability or the risk of lawsuits, it may be worth incorporating sooner rather than later.
- Long-term goals: If you plan to scale, bring on partners, or sell your business eventually, incorporation should be on your radar.
- Tax considerations: Depending on your revenue and profit margins, incorporating could offer some tax advantages, but it’s important to talk to your accountant first. There may also be tax consequences when moving from a sole proprietorship to a corporation, so proper planning is key.
For many, the right time to incorporate comes down to growth, liability, and the desire for personal protection.
Choosing the Right Legal Structure for your Business
Now that you’re equipped with the knowledge about these legal structures, here's what to do next:
- Assess your current business situation: Consider where your business is now and where you want it to go. Are you just starting out or looking to scale? How risky is your industry in terms of liability?
- Consult with professionals: Before making any decisions, consult with both an accountant and a business lawyer. They can help you evaluate the tax and legal implications of incorporating or forming an LLC based on your unique situation. I definitely recommend talking to your accountant if you are incorporating after you’ve started doing business already - there may be tax consequences of doing so, that can be deferred if you take appropriate steps.
- Weigh the risks to your personal assets: If you’re a sole proprietor, take a hard look at the risks you’re taking with your personal assets. Do you feel comfortable with the liability you currently hold?
- Start the incorporation process: If you and your advisors determine that it’s time to incorporate or form an LLC, start the paperwork. Remember, incorporation comes with additional responsibilities, such as corporate filings and separate tax returns, but the long-term benefits could be worth it.
Legally Protecting Your Business as You Grow
Choosing the right legal structure is a critical decision for any business owner. Whether you’re sticking with a sole proprietorship for now, entering a partnership, incorporating a company, or forming an LLC, the key is educate yourself at all stages of the process.
And lastly, the legal structure that’s right for your business today may not be right tomorrow. Revisit this decision as your business evolves, especially if you’re entering new markets, offering new services, or growing your team.
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