When you start a new business, you can structure it as one of the following types:
- Sole proprietorship
The simplest is a sole proprietorship – an unincorporated business with one owner. You make all the decisions, receive all the income and claim all the losses. You carry all the risk of the business, and liability for the business extends to your personal assets.
You can operate the business under your own name or under a registered business name. But, however you do it, the net income created by the business is reported on the T2125 form and is included on your personal tax return (T1). Generally, sole proprietorships have calendar year-ends (December 31).
You may decide to start your business with a partner and run it as a partnership. (Partners are not always individuals; they can also be corporations or even existing partnerships.) A partnership does not file a tax return because it is not considered to be a separate “person” by Canada Revenue Agency (CRA). Instead, the partnership calculates its net income or loss and then allocates it proportionately to the partners in accordance with the partnership agreement. The partners then individually report their shares on their own tax returns. If the partner is an individual, he/she will report it on his/her T1.
One important advantage of a sole proprietorship or partnership is that business losses in the early start-up years can be used to offset other sources of income you may have, such as employment or investments. If you can’t use the losses in the current year, you can carry them back for three years and recover taxes previously paid. You can also carry them forward for 20 years if they were incurred after 2005.
For tax purposes, a corporation is a separate “person” – similar to an individual. As a result, you have to file a corporate tax return called a T2 for your company within six months of its year-end. Corporations do not have to have a calendar year-end; you can choose any year-end that makes sense for the business. You also have to file a personal tax return to report your personal income. This may include income you receive from your company as salary, bonus, dividends or some combination of them. Salaries and bonuses are deductible business expenses of the corporation and are taxable to you personally as employment income – CRA considers sole shareholders of owner-managed corporations to be employees. Dividends you receive from your corporation are treated as investment income.
Corporations have limited liability – that is, liability for the business is limited to the corporation’s assets and does not extend to your personal assets. Corporate tax rates differ from individual tax rates and there are special corporate tax rates for small-businesses.
We’ll explore these issues in more detail in the final blog post in this series.