When you start a business, a key first step is to choose the form of business organization that most suits your business plan. Two of the structures you will likely consider are the corporation and the limited partnership.
Questions to Help You Decide
Deciding which type of business structure to use can be difficult.
Some questions to ask when choosing among various business structures include:
1. How easy and costly is the form of business structure to organize?
2. How much capital will the business need?
3. How much capital will come from owners and how much debt financing will be needed?
4. What are the tax implications of each business structure?
5. How much personal involvement should the owners have in controlling and managing the business?
6. How much risk and liability for the business should the owners assume?
Discuss these questions and other aspects of setting up a business with your accountant.
Both entities are alike in that they each can be owned by several people. But that is typically where the similarities end. Partners in a limited partnership face issues that are diametrically different from those shareholders of a corporation must deal with and the main reason many people choose that form of partnership is tax liability.
Limited partnerships are often used where investors want the special tax treatment without incurring personal liability for all the partnership’s debts.
Limited partnerships generally are taxed on a flow-through basis. That means the partnership doesn’t pay tax on its income and doesn’t file an income tax return. Instead, the partners file their own income tax returns to report their share of the partnership’s net income or loss.
Any income the limited partnership earns is directed to and taxed in the hands of the partners. As well, any losses are allocated among the partners and may become deductions for each partner.
Limited partners are restricted in their ability to deduct losses and in aggregate can’t deduct losses that exceed the amount they have invested. This restriction can be less than the amount invested if the partner bought their interest from a former partner and not the partnership.
This requirement for each partner to report his or her share of the partnership’s net income remains whether the share of income was received in cash or as a credit to a capital account in the partnership.
Limited partnerships are used, for the most part, as a method for structuring tax driven investment ventures. If the investment is tax driven, the limited partnership may have to register with the Canada Revenue Agency as a tax shelter.
In a corporate structure, on the other hand, the company is a separate taxable entity and pays its own taxes. Profits paid to shareholders as dividends are also taxable. This double taxation is one of the disadvantages of forming a corporation.
Other advantages of limited partnerships include:
Liability: When a limited partnership is formed, one of the partners (usually a corporation with no assets, formed and controlled by the promoter of the investment for this sole purpose) is designated as the general partner and all other investors are usually designated as limited partners. The partnership agreement then makes the general partner responsible for managing the business of the partnership. The limited partners are simply silent investors with little or no say in the business activities of the partnership.
In the event the limited partnership is unable to meet its obligations, only the general partner will be liable for the debts of the partnership. The liability of a limited partner would be limited to the amount of capital the limited partner invested in the partnership. However, if the limited partner participates in the management of the partnership, that partner would lose his or her limited liability and may become liable for the debts of the partnership, the same as the general partner.
In a corporation, shareholders can be held liable only for the amount that they invested in the company.
Management: In partnerships, the management structure is decided by the partners. Legally, a corporation must be managed by a board of directors elected by the shareholders.
Life Cycle: Limited partnerships depend on the active participation of the general partner and contributions from the others. As a result, the entities’ life cycles are limited. When the general partner dies, the partnership terminates.
Limited partnerships are usually created for one business reason or to invest in businesses. It is often difficult to transfer ownership because it is generally necessary to create a new partnership.
A corporation, on the other hand, has a virtually unlimited life cycle. Because ownership is spread among shareholders, it can be easily transferred. And if a manager dies or quits, the company can easily recruit a new one.
Record-keeping: A partnership typically isn’t required to keep records of its meetings and other administrative activities. A corporation must keep those records of these activities.
Structure: Limited partnerships must have at least one general and one limited partner. The general partners control the daily management while the limited partners generally have little control over management decisions and primarily finance the organization.
Corporations are separate legal entities usually owned by one or more people or other organizations. Typically the owners, or shareholders, elect a board of directors. That panel, in turn, hires a management team.
Essentially the board runs the organization in the interest of shareholders. To do this, it follows the company’s bylaws, which are the rules that govern how the business should be managed.
Consult with your advisor, who can help you decide the best business structure for your needs.