Starting Your Business
Legal Issues to Consider

R. Brock Johnston
Tel. 604.643.3116, rbj@cwilson.com

Advantages: Again, a partnership has the advantage of simplicity. A partnership can exist between individuals or corporations or any combination of individuals and corporations. No written agreement is necessary to establish a general partnership, and while in British Columbia a partnership declaration should be filed under the Partnership Act, this is an inexpensive, one-time filing. Note that a partnership may well exist even though no filing has been made.

Disadvantages: Partnerships are subject to all of the disadvantages to which sole proprietorships are subject. While it is possible to create a limited partnership, pursuant to which the limited partners enjoy limited liability, because a limited partner cannot participate in the management of the limited partnership’s business, limited partnership is not a viable business vehicle for most small businesses. In addition to the fact that partners have no limited liability in connection with the business of a general partnership, they are also subject to fiduciary duties to their partners.

Furthermore, the partners must be concerned about the liabilities to which their partners may bind them and for which they may unwittingly be liable. Unless a partnership of corporations is established, or the law requires that individuals carry on business in general partnership, as is effectively the case for some professionals, a general partnership is usually not the best way to carry on business.

Partnership Agreement: As noted, a written partnership agreement is not required to establish a partnership, but such an agreement is very important and strongly recommended. It will deal with such things as identification of the partnership’s name and scope of business; admission to the partnership; identification of business which requires agreement of all or a special majority of the partners; capital contributions; rights to distributions; whether partners have special voting rights or interests disproportionate to their capital accounts and dissolution.

Key Tax Issues: Business income or loss from a partnership is business income or loss for the individual partners, and as with a sole proprietorship, will be determined on a calendar year basis. Whether the distributions of income from the partnership equate to its income is irrelevant from the point of view of the tax liability of the partners: the partnership is not a separate entity from its partners for tax purposes. The partners’ interest in the partnership, which ordinarily equates to the capital of the partner invested or retained in the partnership, is a capital property, and if it is distributed, it is a distribution of capital which reduces the partners’ cost base in the partnership. One key advantage of a partnership from a tax point of view is that losses of the partnership can be flowed through to the individual partners. While partnerships are not separate legal entities from their partners or treated as having separate existence for income tax purposes, they are treated as separate persons for GST purposes.

Advantages: The principal advantage of a corporation is that it has a legal existence separate and apart from its members or shareholders. In most circumstances, it has all of the powers of a natural person. It can own property, enter into contractual relationships, earn income, suffer losses and can retain the benefit of its profits without distributing its profits to the persons who own the corporation. A corporation lends itself to more sophisticated ownership and management structures than a partnership; different classes of shares in a corporation can be created which have different voting rights, different entitlements to dividends and different entitlements to distributions on dissolution. If the corporation becomes insolvent, in theory, liability of its members or shareholders should be limited to their invested capital. Corporations can be established for specific business ventures to minimize the risk of loss with respect to those ventures, and corporations can own corporations or enter into partnerships. There are also significant tax advantages, highlighted below.

Disadvantages: Corporations must be separately incorporated and require annual corporate filings. Cost of incorporation and organization of a simple British Columbia corporation, including governmental fees, which make up the bulk of the cost, is typically in the range of $1,000. Annual filings are required and the B.C. government’s fee for an annual filing is currently $35 and there is the cost of preparing these filings and annual resolutions. A minute book must be maintained, and as a corporation is separate from its owners, important transactions will require corporate resolutions and other formalities which may increase costs. If the corporation carries on business in jurisdictions outside of B.C., it will need to be licensed and make corporate filings in those jurisdictions as well.

It should also be borne in mind that in the case of many small businesses, sophisticated third parties, such as banks or landlords, are only too well aware of the advantages of limited liability, and will insist on personal guarantees from the principal shareholders of the corporation. As well, many statutes impose personal liability on officers or directors for such things as maintaining employee remittances, environmental compliance and other public duties.

Incorporation: In British Columbia, a memorandum of association is filed which will provide key details on the share capital structure of the corporation. The shares will be owned by the member shareholders who will appoint directors. The directors, who can be considered the mind of the corporation, will in turn appoint officers, such as the President, Secretary and Vice Presidents, who can be considered to be the arms and legs of the corporation. They will represent the corporation in its business dealings with third parties. In a small business, it is not uncommon for the member shareholders, directors and officers to be the same persons. The affairs of the corporation will be regulated by its articles, which equate to corporate by-laws in most other jurisdictions. These govern such things as conduct of meetings of shareholders and directors, transfers of shares, borrowing powers and ordinary signing authorities. Key business transactions will be authorized by resolutions passed by the directors, either at a meeting of the directors or by consent resolution signed by all directors.

Shareholders Agreements: Where a corporation has members which have different interests, and even if the members are not at arm’s length to each other (as in the case of corporation owned by family members), it is a good idea to have a shareholders agreement which governs such things as scope of the corporation’s business; financing and dividend philosophy; who can become a shareholder; when the corporation will be wound up; when or if one shareholder can insist that that his interest be bought out or if she can require other shareholders to sell out to her. In some jurisdictions, a unanimous shareholder’s agreement can effectively displace the authority of the board of directors. In B.C., the shareholders agreement can only effectively require that the shareholders vote to appoint directors, and that the shareholders will vote to remove directors who do not act in conformity with the shareholders agreement.

Key Tax Issues: Obviously, it is impossible to embark on a meaningful discussion of corporate tax in the space available. The most important thing to remember is that a corporation is taxed as a separate entity from its shareholders at the applicable corporate rate. Expenses, including directors’ fees, salaries, bonuses or legitimate consulting fees are ordinarily deductible from income, even if paid to shareholders. A corporation pays taxes at a rate lower than the rate applicable to higher income individuals. The rates vary depending on whether or not the income is earned from manufacturing and whether or not the corporation is a Canadian controlled private corporation and earns active business income of $200,000 per annum or less, in which event the combined federal/provincial rate is approximately 20 percent. Income which is not required for expenses or taxes can be retained by the corporation and invested or paid out as a dividend. However, unlike partnerships or proprietorships, losses within a corporation remain trapped in the corporation and cannot be passed on to its owners. No deduction can be claimed for dividends. Dividends will be taxed in the hands of the member shareholders, which leads to an element of double taxation, but dividend income is effectively taxed at a lower rate than other sources of income, by about 15% for someone in the top marginal tax bracket. If shares in a corporation are sold, there will likely be a capital gain, but if the shares are in a qualified small business corporation, an individual has a lifetime exemption with respect to the first $500,000 of capital gains on such shares.

Other issues, such as the rollover of a business and its assets into a partnership or corporation on a tax free basis; intercorporate taxes; taxes where transactions occur or business is conducted in more than one jurisdiction; the advantages and perils of income splitting; the implications of trusts and a whole host of other issues may be very important but cannot be discussed here.

General: If you have incorporated your business, ensure that in your dealings with third parties, they know they are dealing with a corporation. Your business cards and letterhead should include the full name of your corporation, including the word "Limited", "Incorporated", "Corporation" or their abbreviations. Make sure that contracts and important letters are signed by officers on behalf of the corporation, and not in their personal capacity. Whether or not you sign as an individual guarantor in support of the corporation is a matter of negotiation, but many people with whom you deal will insist on personal guarantees if the corporation has no track record or significant tangible assets.

Landlords: One of the most important single contracts a small business may enter into is a lease. Most leases are very sophisticated documents. Of key concern to the tenant will be basic rent, term of the lease, what additional rent will be payable on account of occupancy costs and taxes, limitations on access outside of business hours, relocation clauses, rights to renew and freedom to assign or sublet. Small businesses can expect landlords to demand personal guarantees for corporate tenants. Flexibility to assign or sublet without restriction is very important if you foresee selling the business.

Suppliers: Suppliers will typically have standard form documents with lots of fine print. Alternatively, they may want you to enter into a master agreement, with invoices for services or materials being made subject to this master agreement. Typically, these agreements will set out payment terms, rates of interest on late payments, confirm that there are no representations or warranties and state that ownership of the goods sold does not pass until they are fully paid for. These agreements "have teeth" and should be reviewed carefully, especially any provisions which say that the goods or services supplied come without representation or warranty: if you expect product support or warranties, make sure that you have these contractual rights in your third party agreements.

Customers: Consider setting up similar documentation with your customers as you receive from your suppliers. Consider stipulating interest for late payment. Consider how you will enforce payment and how it can be secured. Consider guarantees, and that the Sale of Goods Act implies representations of merchantability, fitness for purpose sold etc. which can only be excluded by contract. Any statement you make regarding the services or goods you are selling, whether or not in writing, may be taken as a warranty. Note that consumers have special rights, including that basic representations as to goods sold cannot be excluded. Consumers also have special rights of rescission in certain circumstances.

The Internet: The internet is opening up whole new ways of doing business, but the legal principles underlying contractual relationships remain unchanged. Who are the parties to the transaction? How creditworthy are they? Has there been offer and acceptance? Are the terms of the transaction sufficiently certain to be enforced? Is there evidence that agreement has been reached? On top of these basic elements are all the confidentiality, encryption, security for payment and other issues which the internet raises.

It is impossible to touch on all the legal issues facing even the smallest startup business. This publication should be taken as nothing more than an introduction to some of the basic legal issues before you. However, one thing that you should consider whenever you are facing an issue which has legal ramifications: an ounce of prevention is worth several pounds of cure. It therefore often pays to consult early with an experienced lawyer on your business issues before they turn into misunderstandings, disputes or litigation.

R. Brock Johnston