Starting your own business can be an overwhelming and exhausting process. Not only are you trying to learn how to make your products and get them into the hands of your customers, but you’re also trying to navigate the behind the scenes aspects of the business. Most new small business owners do not have a degree in business or accounting and can find the start up process very confusing. Knowing how to properly register and structure your business in Canada is very important.
First, know that I understand how you’re feeling as I’ve been there myself. I navigated the unknown-to-me world of small business ownership through extensive research and help from other business owners. I am here to provide you with the information you need to know when starting your own small business in Canada. My hope is to make this process both simpler and less stressful, and counter the misinformation that is often spread through Facebook crafting groups.
This is the first of a four-part blog series in which we’ll discuss the proper way to set up your small business in Canada. In this post, we’ll identify whether your actions are considered a business or a hobby and outline the different ways to structure your business. Follow the rest of the blog series below:
- 1: Business Structure – Identifying & structuring your business
- 2: Provincial Registration – Registering your business name & PST/QST accounts
- 3: Federal Registration – Obtaining a business number & registering for GST/HST
- 4: Licensing & Insurance – Municipal business permits/licences & small business insurance
This post is informative only and is based on my knowledge and experiences. Please consult with a local professional for the best information for your business. This post may contain affiliate links, which means that I may earn a commission on any sales at absolutely no extra cost to you. Review our Policies for more info.
Small Business or Hobby?
One statement I see mentioned very often by people selling their crafts on Facebook or even through platforms such as Etsy is, “I’m not running a business, I’m just doing this as a hobby.” If this is true, does that mean none of the business registration rules apply to these people?
That is a very good question and one worth looking into. For answers, let’s first take a look at what the Canadian Revenue Agency (CRA) considers a business.
Defining “Business”
Here is the CRA’s definition of business. An interesting thing to note is that their definition is different in regards to income tax than it is for sales tax.
Forย incomeย tax purposes, we define a business as an activity where there is a reasonable expectation of profit and there is evidence to support that intention.
For goods and services tax/harmonized sales tax (GST/HST)ย purposes, a business also includes any activity whether or not it is engaged in for profit….
CRA | Checklist for Small Businesses
In regards to whether or not the CRA considers your activities as a business, the key lies in the “expectation of profit“. Are you selling an item for more than it costs you to make? Are you trying to sell more of these items? If so, you appear to be expecting to earn a profit off the sale of these items.
Other factors that the CRA may use as part of their “Profit Test” include the amount of time you spend on these activities (do you do these only a few hours a month or several hours a day/week?), your qualifications (such as training, education, etc. related to the business activities), steps you’ve taken to set up your business (such as preparing a business plan), and any marketing of your products (are you advertising these items for sale online or participating in local markets?).
So, if it can be shown that you have taken steps to set up what appears to be a business, have a reasonable expectation of profit by selling your items for more than cost, are marketing/advertising your products for sale, and/or have invested in business equipment or training, etc. then it is very likely that the CRA will consider your activities as those of a business.
Hobby Sellers
On the flip side, for your activities to be seen as a hobby only, you have to be selling without expecting to make a profit. For example, say you knit a scarf one Sunday and sold it to your neighbour for less than the material cost. You haven’t invested money in equipment or supplies to make more scarves, you’re not advertising your scarves for sale or intending to continue to make and sell scarves. Then you can likely consider the sale of this scarf a hobby. You would therefore not need to comply with the business registration process.
It is possible that you may begin an activity as a hobby and have it turn into a business. In the example above, perhaps you decide at a later date that you thoroughly enjoyed making that scarf and conducted some research to discover that there is market for hand-knit scarves. You purchase a bunch of material to begin making more scarves and list your products for sale online. It now appears that you are turning these activities into a business.
How to Structure your Small Business in Canada
The way you structure your small business affects how your business pays you and how you file your income tax with federal government in Canada. There are three main options for your business structure: sole proprietor, partnership, or corporation. Let’s identify what these mean and highlight some of the advantages and disadvantages of each.
Sole Proprietor
The most common business structure for new small businesses (in Canada or elsewhere) is sole proprietorship. Being a sole proprietor means that you are the only person running and making decisions on the business. The business is connected to you, both personally and legally. It is linked to your SIN (Social Insurance Number) and all business earnings or losses are considered part of your personal income. You are responsible for all of the business risks, which means that if you run into any legal or financial issues, your personal property and assets are also at risk. You can carry out business activities under your own name or a separate business name.
Sole Proprietor Tax Reporting
When reporting income tax, you will report business income and expenses with your personal tax return using Form T2125.
Sole Proprietor Advantages
- Easy to set up and maintain
- Low registration & filing costs
- More freedom & flexibility
- No need for a separate business bank account
- Simple tax reporting
- Receive all profits
Sole Proprietor Disdvantages
- Sole financial responsibility, harder to raise capital
- Assume all risks & liability, which are tied to your personal assets
- Difficult to transfer the business to another owner in the event of the proprietor’s death
If you are starting a new small business by yourself in Canada, I highly recommend the sole proprietor business structure. It is relatively cheap and easy to set up and maintain. Plus, you can always incorporate at a later date when your business has grown to a level where that makes more sense. To offset the biggest concern with sole proprietorship – liability, you should obtain business insurance to protect you in the event of a lawsuit. For more information on this, check out Part 4 of this blog series.
Partnership
If there is more than one person running your business, you may consider structuring your small business as a partnership. A partnership consists of a relationship between two or more individuals or corporations (there is no limit to the number of partners). Each partner contributes money, work, property, or skills to the business and thereby earns to a share of the profits & losses. Partners may be contributing equally to the business and thus dividing the profits equally. Or one partner may be contributing more time, money, and/or expertise to the business and will be receiving a larger share of the profits as a result.
All that is required to establish a partnership is a simple verbal agreement. However, it is strongly advised that you have a written agreement to document what each person/party will contribute and how the profits will be divided. You should also establish what will happen if one of the parties wants to leave or dissolve the partnership.
There are different types of partnerships, depending on how your arrangement will work between the parties. The two main structures for handmade businesses would be:
General Partnership
This is the most common type of partnership. Each partner shares the profits and liabilities of the business. Like sole proprietorship, each partner is personally liable for the debts, contractual obligations, and legal liabilities of the business.
Both partners are involved in the operation of the business, although their contribution level may differ depending on the arrangement. You may share all work evenly or split up tasks to suit each partner’s strengths.
Limited Partnership
In this partnership, there are two types of partners. General partners have full liability and limited partners have limited liability as related to their contributions. This type of partnership is often set up with a corporation acting as the general partner operating the business & accepting full liability, with two or more individuals acting as limited partners.
Limited partners, also known as silent partners, don’t participate in the operation of the business. They may provide financial contributions and advice. If they become more involved in operating the business, they would lose their limited liability and become a general partner.
Partnership Tax Reporting
When reporting income tax, each partner will report their share of the business income and expenses with their personal tax return using Form T2125. The partnership itself does not file any income tax returns.
Partnership Advantages
- Low setup costs
- Relatively simple tax reporting
- Access to more skills & experience through multiple partners
- Shared start up costs
Partnership Disadvantages
- Consensus needed for business decisions; less flexibility
- Can negatively impact partners’ personal relationships
- General partners assume all risks & liability, which are tied to their personal assets
- More revenue needed to support multiple people
Some people choose to go into business with a friend or family member, so a partnership is likely the way you will structure your small business. While this can be a great way to minimize some of the costs and risks of starting a business, it can also be hard on your relationship. Mixing family/friends and finances can be very tricky to navigate. Resentment can build up easily if one of you finds themselves pulling more weight. The business also needs to bring in enough money to support two people. These are all important considerations to take before entering into a partnership.
Corporation
When your small business has grown, it may be time to change the business structure to a corporation. If you incorporate, the business becomes a separate entity and is no longer connected to you. Incorporating a business is expensive and adds increased reporting requirements. Members of the company generally are not responsible for the debts, contractual obligations, or legal liabilities of the business. There are a few exceptions to this:
- If you secured business funding with a personal guarantee, you are responsible for paying those debts if the business fails.
- If you commit an act of negligence in conducting business, you can be held personally liable
- Business directors can be held responsible for fraudulent acts
- Failure to pay taxes or file reports
The business expenses, profits, and losses must be kept separate from your personal finances. All of the money stays with the business and you pay yourself either as a salary or dividend payments. If there are multiple owners, each will receive shares proportionally related to their percentage of ownership.
Federal vs. Provincial Incorporation
You will most likely want to incorporate both federally and provincially, which are separate processes. Incorporating federally allows you to carry on business across the entire country (as long as you register in all provinces & territories) using the same name (even if another company exists with that name in a particular province). The business will also be recognized internationally. However you will face stricter name requirements and paperwork filings; you’ll need to file federally as well as in all provinces/territories.
If you incorporate provincially, the business is only authorized to operate in that one province. You may register in multiple provinces if your business operates in those provinces only, not the entire country. This may be a better process for you if your business is small and only conducting business in one province for now. You can always incorporate federally or in more provinces later if your business expands.
Corporation Tax Reporting
The business will need to file its own income tax return using Form T2. You will include any payments made to yourself from the business on your personal tax return.
Benefits of Incorporating
- Better legal protection for your personal assets
- Potential tax savings/deferrals
- May qualify for the federal small business deduction, further lowering tax rates
- The business lives on after the owner’s death. It can more easily by sold or transferred to another person.
- Access to better financing rates
- Perceived as more stable company, which may bring more business
Disadvantages of Incorporating
- Increased costs to incorporate
- Annual filing costs
- More administrative work
- Multiple owners minimize flexibility in business decisions
- Less tax flexibility
- More difficult to dissolve/close the business
One of the biggest advantages of incorporating is the potential for tax savings. This is because the tax rates for corporations are typically less than personal tax rates. In order to benefit from this, your business has to be making more money than your personal living expenses. For example, if your business makes $100,000 and you need $60,000 for your personal expenses, you can take only what you need and leave $40,000 in the business. Now instead of paying personal income tax on the $100K, you would be paying personal tax on $60K and corporate tax on $40K.
If all of your business income is currently going towards your personal expenses, it is generally not worth incorporating yet. You would be incurring extra fees and admin work to incorporate and not seeing any tax savings. You may be better off starting with a different structure for your small business in Canada.
Next Steps
You’ve identified whether you are running a small business based on the definitions for sellers in Canada and decided how best to structure it. The next step is to register your business with your provincial government. Find out what that entails in “Part 2: Provincial Registration”
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