AN OVERVIEW OF INCORPORATION

What is a Corporation?

A corporation is a separate legal entity that exists independently from its owners (the shareholders). A corporation has the capacity, rights, powers and privileges of a natural person, so that it can carry on business, own property, borrow money, possess rights and incur liabilities. Commercial activity is generally carried on through a corporation to limit liability. A corporation is created when the company complies with the appropriate municipal, provincial, territorial or federal business licensing requirements, and completes the necessary registration requirements under the Ontario Business Corporations Act (the “OBCA”) or a similar statute in another province or territory of Canada, or the Canada Business Corporation Act (the “CBCA”), depending upon the jurisdiction where the business is incorporated.

There are three main roles in a corporation: shareholders, directors, and officers. While these roles are notionally separate and can be filled by different people, the same person may actually perform some or all of the roles.

The shareholders own the corporation through their ownership of shares. Shareholders do not personally own the assets of the corporation, nor are they personally liable for the liabilities of the corporation, except in limited situations. Furthermore, the share capital of a corporation can be divided into several classes or series with different rights attached to each class.

Directors (which comprise the Board of Directors) usually oversee the management of the corporation. This includes tasks like setting the direction of the corporation and deciding whether to declare dividends to pay out to shareholders. Directors are elected by shareholders, and their meetings are subject to statutory requirements. As noted above, the director role and the shareholder role can be performed by the same person. If the Business were to be incorporated, you could fill both roles. This would allow you to take advantage of the limited liability offered as a shareholder, while still enabling you to manage the Business as a director. (See page 6, “Limits on Limited Liability” for further discussion).

The day-to-day operation of the corporation is typically managed by its officers, who are appointed by the directors. Officers can be employees of the corporation and earn a salary, which will be taxed at applicable marginal income tax rates. Corporate operations are subject to the provisions of the corporation’s articles of incorporation, its by-laws, any shareholder agreements, the applicable corporate statutes and the common law. It is possible for you to be the sole officer (usually President and Secretary) of the corporation.

Shareholder Agreements

A shareholder agreement is an agreement relating to the relationship between some or all of the shareholders of a corporation. The agreement must be in writing, and must be signed by the shareholders, though not necessarily all of the shareholders. If you will be the sole shareholder of the company, then a shareholder agreement is not necessary; however, there may be some value to putting in place a shareholder agreement now in the event that you intend on adding additional shareholders down the road. Given the uniqueness of each Shareholder Agreement and the fact that it is difficult to predict what issues future shareholders may want to address, it probably does not make sense to put a Shareholders Agreement in place at this time.

Perpetual Existence

A corporation exists until it is dissolved and therefore can exist beyond the lifetime of its original shareholders, directors and officers.

ADVANTAGES OF INCORPORATION

1. Limited Liability

The main advantage of incorporating the Business is limited liability. Limited liability exists by virtue of the fact that a corporation is a separate legal entity from its shareholders. Unlike a sole proprietorship, shareholders do not personally own the assets of the corporation and, generally speaking, would be entitled to benefit from limited liability protection available to a corporation’s shareholders. A shareholder’s liability is generally limited to the value of the assets they have transferred to the corporation (in the form of money, property or past service) in exchange for shares.

Limits on Limited Liability

As discussed in more detail below, shareholders who, in their personal capacity, guarantee the obligations of the corporation will effectively lose their limited liability status. It should be noted that in certain exceptional circumstances, courts may “pierce” the corporate “veil” of limited liability, such that personal liability may be found against the shareholders. In other words, you could be held personally liable for the debts of the corporation. To protect against liability in your capacity as a director or officer of the company, you should do the following:

• Avoid all fraudulent conduct: Do not engage in fraud or any activity that appears fraudulent. Courts might hold you personally liable even if no fraud actually occurred, so long as it appears that it may have.
• Always be clear that the Business is incorporated: Be sure to notify all the Business partners (suppliers, customers, banks, etc.) that they are doing business with a corporation and not you personally; that is, they are only dealing with you in your capacity as an officer or employee of the corporation. You can do this by putting the company name on all your invoices, purchase orders, and other communications, and by ensuring that all contracts are executed by you in your capacity as an officer or director of the corporation, and not in your personal capacity.
• Perform all corporate formalities: Even if you are the sole shareholder and director of the corporation, you must perform corporate formalities, such as holding shareholder meetings and director meetings.
• Keep a clear separation of funds: Do not mix your personal accounts with the corporation’s accounts. If you do, a court may not recognize the separate existence of the corporation. This separation of funds can be facilitated with the creation of a business bank account (which you may already have established). The use of this bank account should be limited to depositing money from the Business and paying off expenses from the Business.
• Ensure adequate capitalization: This means you must ensure that the corporation has enough assets to cover its liabilities. If the corporation is constantly under-funded, a court may perceive that a corporation is a mere “shell” that is created to avoid liabilities.

Even if the above points are adhered to, a director of the corporation may still be held personally liable in certain cases. As such, you may be exposed to personal liability subject to sections 130 through 138 of the OBCA or similar provisions of other corporate statutes. Such cases include personal liability for source deductions for employees, H.S.T. which is collected by the corporation but not remitted, up to six months’ unpaid wages to employees, and up to twelve months’ accrued vacation pay for employees. Note that this list is not exhaustive, and there may be potential liability under federal and other provincial statutes.

It is important to note that, practically speaking, for a new small business the limited liability of a corporation may not be as advantageous as it first appears where the corporation is debt financed. This is because many small business transactions, such as a bank loan or a lease, require a shareholder or director to personally guarantee the obligations of the corporation. If the business does not have sufficient assets, a bank may require that you pledge your personal assets as collateral for any loan to the business, which would have the effect of exposing your personal assets to liability. However, personal liability for such matters as civil lawsuits for product liability would still be avoided.

2. Raising Money

A corporation is a good vehicle for raising capital. For example, if you wanted to expand the Business, you could sell shares to prospective investors in return for money or other capital. However, before considering seeking additional investors, you should obtain legal advice on the requirements and restrictions imposed by securities laws.

3. Prestige

There is a certain degree of public prestige associated with doing business as a corporation; it can generate a sense that it is a “serious business,” since it has undertaken the formality of incorporation.

4. Pension Plans and Profit Sharing Stock options

Although this may not be relevant to the Business at this time, a corporation may set up pension plans and profit sharing stock option plans for the benefit of its employees.

5. Transferable Ownership

The ownership of a corporation can be transferred through the transfer of shares. This feature may be useful to you in the future if you decide to sell the Business. When you obtain tax advice, you may also wish to discuss the tax advantages of selling shares of a corporation rather than the business assets themselves.

The combination of transferable ownership and perpetual existence (discussed above under “An Overview of Incorporation”), may create options for the Business that may not be attainable without incorporation.

DISADVANTAGES OF INCORPORATION

1. Costs of Incorporating

The incorporation of the Business will involve several costs. The initial cost will be the filing fee charged by the applicable government branches (the Ministry of Government Services, in Ontario). The current filing cost for an Ontario incorporation is $360 for the over-the-counter (in person) paper filing service, and $300 for an electronic filing. The costs for federal incorporation are $250 for paper filing and $200 for electronic filing. Please note that the listed electronic filing costs only include the fee to the applicable government ministry, and do not include the service fee charged by the chosen electronic service provider or professional adviser; the total cost will likely be considerably higher.

In addition to the filing fee, further costs must be incurred for a name search and the purchase of a corporate minute book.

2. Extensive Record-Keeping and Filing Requirements

Since a corporation is a separate legal entity, it must keep proper records and must make annual filings to the government. Compliance includes the following:

• Minutes and Resolutions: Records of shareholder and director meetings, as well as resolutions must be documented in the corporate minute book.
• Filing an annual corporate income tax return: This tax return is separate from your personal tax return and is calculated based on the revenues and expenses of the business. Corporate tax rates and rules differ from those for individuals, and thus preparing for and filing this tax return may increase your annual tax filing costs.
• Keeping corporate records updated: Changes to various aspects of the corporation must be recorded. These include changes to the registered officers, any changes with regards to directors, and changes to the articles of incorporation (which may encompass restrictions on share transfers or the type of business the corporation carries on). Also, the shareholders’, directors’, and officers’ registers must continually be updated to reflect the status of those roles within the corporation.
• Filing an annual return: This filing is to contain up-to-date information about the corporation, such as information about the directors and officers. The administrative requirements of this return differ depending on whether the corporation is federally or provincially incorporated. If federally incorporated, this is a separate filing in addition to your income tax return, but if provincially incorporated, this return forms part of the corporate tax return. The federal filing costs $20-$40, depending on the method of filing; provincial filing does not require a fee.
• Preparing a share register: This register shows the names and addresses of all shareholders and details of shares held.
• Preparing a director’s register: This register would record the name of the directors appointed to represent the Business.

These continuous filing and reporting obligations are an administrative burden and may have related costs for preparing and filing. Such costs and administrative obligations could be avoided by maintaining operation as a sole proprietorship.

JURISDICTION OF INCORPORATION

In Canada, a corporation can be incorporated provincially, territorially or federally and is governed under the OBCA (or another applicable provincial or territorial statute) or under the CBCA.

With federal incorporation you have the right to carry on business anywhere in Canada, subject to the license and registration requirements of each province. There is no additional fee to register in Ontario, but there are applicable fees in other provinces. If you choose to incorporate provincially and then decide to carry on business in provinces or jurisdictions other than Ontario, an extra-provincial or foreign registration would be required.

There are both advantages and disadvantages to each type of incorporation. Keep in mind however your decision will likely turn on the size and type of market you wish to access.