Asset Protection

I want to become an entrepreneur and start a business. Should I incorporate now, or start as a sole proprietorship and delay incorporation to a later date?‍

The advisability of incorporation is dependent on the particular facts and personal preferences of the entrepreneur. The role of the Lawyer and other professional advisors is to help draw out the relevant facts and explore personal preferences to assist the entrepreneur in making the decision that is right for her. Some of the relevant factors include:

‍Risk. Is the proposed business inherently risky? The shield of limited liability that an incorporated entity provides to the entrepreneur is an important benefit (note that the shield from liability is not absolute);

‍Tax. A valuable attribute of an incorporated entity is the relatively low tax rate (approx. 16%) payable on the first $500,000 of net income. This allows a profitable incorporated entity to grow much quicker using internally generated working capital than a similarly sole proprietorship where a marginal tax rate in excess of 50% of profits may be payable. An exception is where the sole proprietor has other sources of income and it is anticipated that the new business will suffer losses in the start-up year(s) – it may be possible to set off the losses against the other income and thus reduce the overall tax burden;

‍Costs. Incorporation of the business at an early stage is less expensive than incorporation once the business is up and running. Once the business (sole proprietorship) is up and running it is generally necessary to use a “rollover” transaction to transfer the business from the sole proprietorship to the corporation.

‍Separate Existence. An incorporated entity has a legal existence separate and apart from the entrepreneur. This provides for a number of real and perceived benefits including (generally): broader alternatives for raising capital; easier salability of the business and possible availability of lifetime capital gains exemption to avoid tax on sale, continuous existence past the life of the entrepreneur, public perception of greater substance, and easier separation of personal and business dealings.

I am considering the acquisition of a business. Long term contracts between the business and third parties are important to the business. Do such contracts affect the decision to acquire shares or assets of the business?

‍There are a number of factors to be taken into account when purchasing an existing business including tax, liability, due diligence and employee matters. Your question relates to the contracts between the business and third parties. These contracts may include rights obtained by the business necessary to carry on the business, such as licenses or franchises, or the benefit of sale or service agreements for the supply of products or services that generate revenue for the business.

A fundamental difference between an asset purchase and a share purchase is that in an asset sale the contracts must be assigned (along with the transfer of assets) while in a share sale the contracts remain intact (since only the shares of the business itself are transferred).A comprehensive review of all important contracts is advisable as early as possible during the due diligence process to determine rights and obligations. If third party consents are required, consideration must be given as to the risk that such consents may not be available in a timely manner, or at all, and whether the transaction may be better structured to avoid the necessity for assignment. In some less common circumstances there is an outright bar to assignment and consents cannot be obtained (this is the case in some government procurements). The acquisition of the business in such circumstances may only be achieved through a share sale to avoid termination of such contract(s). It should also be noted that some contracts contain provisions that deem a change of control from a sale of shares to be equivalent to assignment, and triggering the necessity for third party consent.

My husband and I are the sole shareholders and directors of an incorporated retail business. We have been quite successful and are generating cash excess to business requirements. We do not want to pay the cash out to ourselves now, and pay high rates of tax, but at the same time this cash is a significant part of a retirement fund. We have no creditors, other than trade creditors payable in the ordinary course. How do we protect this cash for our retirement?

‍You are asking a good question. In the event of an unexpected economic downturn or legal claim against your active business corporation, the excess cash generated in the business could be exposed to potential creditors. Once the liability is crystalized, it may be too late to take action that will protect the cash. You have also correctly identified that the simplest solution –payment of the cash out to yourselves – attracts undesirable tax consequences.

A cost efficient solution is the creation of a holding corporation. The holding corporation structure, when designed properly, allows excess money from your active business corporation to be paid by dividend to the holding corporation, tax free. The holding corporation is a separate legal entity, and is generally insulated from claims against your active business corporation.

Care is required that the desired tax treatment is achieved in the structuring of the holding corporation. There are other financial planning considerations, such as ensuring the availability of the lifetime capital gains exemption, which must be addressed by the new structure. This type of corporate structuring may also be implemented as part of a broader strategy for business succession and included as part of your estate planning.