Introduction to Corporations
One of the first decisions to make in establishing a business is what organizational structure will be used. This article is part of our Website series on business organizations and discusses the use of corporations, or companies as a specialized structure for carrying out a specific business purpose.
A company, unlike a proprietorship or partnership, is created as a distinct legal entity under the British Columbia Business Corporations Act, and it only exists as a result of that legislation. If the steps set out in that legislation are followed then the company is given government approval and comes into existence as a legal entity just as if it were a natural person, separate and apart from the people who caused it to be created. That company is then able to act as any other natural person, including entering into contracts, selling products, being involved in court actions or filing an income tax return.
While there are many considerations involved in choosing the form of organization, they usually fall into the general categories of income taxation, administration and cost, and limitations on liability. We will now look at how companies are treated in each of these areas.
Companies are separate taxpayers and must compute their taxable income or loss, file a tax return and pay the tax due. Companies may select fiscal years and accounting methods which are different from those of its shareholders in order to minimize or defer income taxes. Withdrawal of funds from the corporation by the principals of the company usually results in taxable income to those principals, but because of the different income tax treatment of dividends, salaries, and bonuses, it may be possible to pay the principals monies in a way which might increase the amount of money the principals would otherwise receive after tax is paid.
The following are some additional advantages obtained by principals who adopt a corporate entity to conduct business:
- Tax deferred rollover of assets to the corporation;
- Flexibility to create and maintain pension and retirement plans;
- Entering into lease and sale transactions to create new depreciable cost base for some assets for which depreciation reductions are otherwise completely exhausted or simply unavailable; and
- Corporations may adopt favourable tax deferred, stock option, and other compensation planning devices in the course of operating the business.
Additionally, the company may create the potential of double taxation of corporate earnings. A company that earns profits must pay tax on those profits at the corporate level before those profits are distributed at the shareholder level where the earnings are paid out as dividends and taxed in the hands of the shareholders. Careful planning must go in to structuring the business the company will carry on to ensure that the principals are no less well off than they would have been carrying on the business as individuals.
Corporations are also more likely to appear on Revenue Canada’s audit list and be exposed to unreasonable scrutiny of their compensation, shareholder benefit and other related tax mechanisms.
Administration and Cost
Unlike a natural person, a company cannot act on its own. Every company has shareholders, directors, officers and employees who carry out the activities of the company. Each of these individuals has specified roles and obligations toward each other and toward the company. In a small business with few people involved, one of the most difficult things for business people to do is to differentiate between the varied roles of the different positions within the company and conduct themselves accordingly.
A shareholder is considered to be an investor in the company which entitles that person to certain rights. The shareholder is risking the investment that he puts up to acquire the shares in the company but his monetary obligation does not usually go further. The rights that a shareholder possesses sometimes surprise people because they are quite limited. Generally, if a company is being properly run, those rights are limited to voting to elect a board of directors of the company, receiving periodic reports about the affairs of the company, and being entitled to a distribution of the company’s profits if any are made. There are other, specialized situations that entitle a shareholder to other rights, but that discussion is beyond the scope of this article. Many people are not aware that this is generally the extent of a shareholder’s rights.
The directors as elected from time to time by the shareholders are the persons responsible for the running of the affairs of the company. Any company’s board of directors can consist of as few as one director and as many directors as the shareholders decide, however there are practical problems associated with having too many directors and their ability to make efficient decisions. There is no correlation between the percentage of voting shares held by any individual at the shareholder level and representation at the board of directors level. The directors make all the decisions regarding the day-to-day affairs of the company, and they each carry one equal vote. For most decisions a majority of the directors carries any decision being voted on by the board of directors.
Each of the directors owes a duty to act in the best interests of the company, and this does not necessarily equate to that person’s best interests as a shareholder. In addition, the directors may have certain liabilities created by government legislation relating to employee’s wages, remittance of taxes the company collects and special situations such as environmental misconduct.
The directors elect the officers of the company, if any, which typically consist of at least a president and a secretary. The powers of the officers are delegated to them by the directors and can consist of as little or as much as the directors consider prudent. The officers of the company may be exposed to the same legislative liabilities that the directors are exposed to as set out above.
If a company carries on business properly, then the company is the party that is liable for the business’ debts and the company’s principals such as the shareholders, directors and officers are not liable for the debts of the company incurred in the normal course of business.
When an individual carries out activities within a corporate structure it is important that they are aware of which role they are playing among the different roles within the company. If an individual confuses the role that he is acting in and oversteps his limitations within that role, he can find himself the subject of court action filed by one of the other individuals involved in the company. There are many possible results of such a court action, even if the individual who overstepped his bounds did so without any bad faith and they include being terminated from a position as a director or officer, losing their employment position, possibly being required to repay any monies gained by that individual, and being forced to buy out the individual who complained about his conduct.
The bottom line is that the rules of conduct and relationships of individuals within a company are quite complex and it pays off in the long run to be aware of the differences within the various roles taken, and to act accordingly.
Establishing a company requires the filing of certain documents with the Registrar of Companies. The preparation and filing of these documents means that the costs of setting up a company are quite a bit higher than other business organizations. Additionally, every year will require the filing of certain documents with the Registrar of Companies in order to preserve the company’s status.
The requirement to prepare and file annual income tax returns means that the costs of administering the books will be higher.
One of the advantages of a company carrying on a business is the limited liability protection granted to the principals of the company, however ongoing tasks must be done by the company’s principals to preserve the company’s status and the underlying limitation on liability. The following are some of the corporate formalities that must be regularly attended to in order to preserve a company’s status:
- filing of articles of incorporation;
- annual returns;
- regular Board of Director’s meetings and an Annual General Shareholder Meeting;
- filing of tax returns and annual accounting records;
- the obtaining of appropriate provincial and local licences; and
- all assets to be capitalized must be legally transferred to the corporation.
Corporations do not die when a shareholder dies and will continue as a legal entity for an indefinite period until the entity is terminated by agreement of the shareholders or by the Courts. This aspect is usually considered extremely beneficial in adopting a corporation as a succession planning device to transfer assets to the next generation of a family.
Ownership of shares is usually freely transferable and there is no limitation on who can own the shares.
Although not required, we recommend that the shareholders enter into a shareholders’ operating agreement with the company in order to deal with issues that are not dealt with in the legislation or the documents that are regularly used to set up the corporation. A shareholders’ operating agreement will deal with issues such as:
- the ongoing management of the company and what decisions may require unanimous agreement of the principals;
- the rights associated with any loans that the shareholders may make to the company;
- the disposition or transfer of shares in the event of death, dispute, disability, or retirement;
- what actions may be taken if a principal is not contributing to the company’s business as was agreed to when the business was started; and
- a mechanism for resolving disputes may be agreed to before a dispute ever arises.
The costs of preparing such an agreement will seem to be unnecessary at the start-up phase, but they will pale in comparison to the costs of resolving issues if a problem develops later and there is no agreement in place.
Limitations on Liability
Often the most important feature of companies is the limited liability protection that a company provides for the principals of the company. If all the proper actions are taken, then shareholders can limit their liability to the amount of their investment in the shares and there is no liability for the debts of the business. The claims against the corporation from which the shareholders can enjoy immunity include law suits against the company, actions of employees, trade creditors, and lenders.
While the principals are not exposed to the general debts of a company, ultimately its officers and directors are required to ensure the company’s compliance with the company’s regulatory requirements. Certain statutes place the corporate liability on the directors and officers of the company if corporate actions are not done, or are done improperly. These include:
- income tax, C.P.P. and E.I. premiums deducted from the employee’s paycheque but not remitted to the Receiver General;
- employer’s portion of C.P.P. premiums;
- employer’s portion of E.I. premiums;
- net Goods and Services Tax not remitted;
- unpaid Worksafe BC premiums;
- unpaid Corporations Capital Tax; and
- unpaid Provincial Sales Tax.
There is an additional source of potential liability for principals to be aware of. Minority shareholders may avail themselves of the “oppression remedy” under the British Columbia Business Corporations Act to potentially make majority shareholders liable for a breach of their fiduciary duty of good faith and fair dealings to minority shareholders, where the actions of the majority may be contrary to the minority shareholder’s interests in the corporation.
Corporations formed by professionals in the pursuit of their profession may not serve to fully isolate the professional/shareholder from liability for negligence and malpractice action, however, specialists may insulate themselves from personal liability for other law suits.
The choice to use a corporate structure to carry on business involves the balance of many different priorities before an informed choice can be made. Ultimately the choice of which structure to use to carry on a business involves a careful understanding of how the business will operate in the future, the various risks that the business will face, and what benefits each structure will provide to the operator of the business. We recommend you speak with our business law lawyers to discuss the relative merits of the different structures before you commence carrying on business.
The opinions set out in this article reflect generally on this area of law. The impact of the law on any given situation depends upon each individual’s circumstances and the opinions contained in this article should not be relied on for assessing anyone’s legal position. Advice should be obtained directly from our business law lawyers regarding your particular situation.