Proprietorships vs. Corporations

The Essential Differences Between Incorporating and Not

Sep 12, 2008

There is often confusion as to whether it is better to incorporate a business or keep it as an unincorporated proprietorship (or partnership). Here's some help.

There are some advantages to remaining a proprietorship, but there are also some disadvantages that should be seriously examined in order to make the best decision whether to incorporate or not. Of course that requires understanding the essential differences between each type of business entity.

Defining a Proprietorship or Partnership

The simplest form of business is a sole proprietorship. This is where a single person decides to start a company, gets the appropriate licensing and registration and simply operates the business under his own name or a trade name. There are no extras, and the owner is 100% responsible for all aspects of the business. The only difference between a sole proprietorship and a partnership is the number of people who own the business. As with any business agreement, a partnership should have a partnership agreement in place before the business starts.

In this case, the owner is liable for all business debts and activities, gets income directly from the company, and is taxed directly for all company activities at the personal tax rates. There is no separate entity. This makes the paperwork easier and for many small businesses this is a good solution.

Defining a Corporation

A corporation is a legally registered company that is considered a separate entity from the owner(s). It must be registered (incorporated) properly, for which fees must be paid, and there is an annual corporate return that must be filed to keep its registration active. A corporation can be a numbered company or a named company. It collects revenue separately from the owners’ income and is taxed through corporate tax rates. Owners can be paid through salary, dividends, or other means. Because it is an independent entity (at least on paper), the corporation can have its own bank accounts, investments, property, and so-forth.

Some Advantages and Disadvantages of Incorporating

Since a corporation is separate from the owners, it builds its own separate credit. This means that the corporation’s credit rating is not tied directly to that of the owner. Only in the early stages of a corporation do the banks worry about the owner’s credit rating, because they will often require the owner to guarantee for the corporation, since it has no credit rating. Once it is a few years old, this requirement can usually be waived. This is advantageous to the owner, because then his assets do not get tied directly into the issues of the corporation. As well, if there are problems with the company, then the lenders cannot come after the owner’s assets (unless he has signed a personal guarantee).

With a proprietorship, the company and the owner are the same entity, which means that the owner is 100% liable for any debts the company incurs. This cannot be separated. As well, all investments and assets are essentially directly the owner’s. With a corporation, there is one step of difference, so that while the company is owned by a person, that person does not directly own the company’s assets (vehicles, equipment, etc.) – these are owned by the company and the company’s debtors can lay claim to them in the instance of non-payment. However, the debtors cannot go after the owner’s assets.

As well, the corporate tax rates are often much lower than personal tax rates, especially for small business. This allows the corporation to have more cash to operate on than a proprietorship (assuming the owner isn’t taking all of the company’s net income, which would then be taxed in the hands of the owner). With this extra cash, naturally a corporation has a better chance of growing faster than a proprietorship would. In the long run this means more money for the owner.

Obtaining investments is another advantage of incorporating. Only a corporation can issue shares of any sort. These are often more attractive to investors than simple loans. With a propritorship, your best chance of raising cash is through love money. And that limits your options.

The real disadvantage of incorporating is that it takes more work. There are more stringent requirements on reporting, therefore the books and records need to be kept more meticulously, and there are some (small) annual filing fees (plus the initial set up costs) that make operating a corporation slightly more expensive.

If your business is always going to remain small and you are planning on drawing all of the earnings out every year, then there really isn’t any reason to incorporate. However, if there are bigger plans for growth, even just financially, then a corporation is likely the best way to go.

The copyright of the article Proprietorships vs. Corporations in Strategic Business Planning is owned by Johanus Haidner. Permission to republish Proprietorships vs. Corporations in print or online must be granted by the author in writing.