On your small business journey, you will encounter many forks in the road. Choosing the right direction for your company as it matures may seem daunting at times. One of the “forks” you must consider is whether or not to move your business from its default sole proprietorship status to another type of legal entity. Incorporating is the most traveled path for entrepreneurs who want to protect their personal assets, experience tax advantages, and build credibility.
Why Incorporate Your Business?
A corporation is a created legal entity that exists separately from those who founded it and carry on its operations. Corporate entities are considered individuals by law – Just like a person, a corporation can buy and sell properties, engage in contracts, file taxes, and commit crimes. Notably, incorporation limits its owners’ personal liability from corporate debts and other obligations such as legal judgments.
Generally, there are three types of legal entities a business can choose to operate as:
- Sole proprietorship: This is the default status for most small businesses started by a single individual. It suggests the business is owned and operated by a sole proprietor. There is no distinction between the business and the individual. A sole proprietorship is not taxed separately from its owner. All business income is considered income for the sole proprietor, and taxes are handled via the owner’s personal income tax returns.
- Partnership: This business status is formally agreed-upon when a business has two or more owners. There are two types of partnerships: General and limited. A general partnership indicates that all individual owners share in the company’s assets, profits, and financial and legal liabilities. A general partnership has unlimited liability, which means the personal assets of all owners are fair game when it comes to business debts and legal issues. A limited partnership is also a legal entity with two or more owners. However, in a limited partnership, one or more partners are committed to the business only on a financial level as investors. That means their level of liability is capped at the extent of their investment. Limited partners are not responsible for the day-to-day operation of the company. Often, angel investors and venture capitalists function as limited partners in a business.
- Corporation: A corporation is a business entity owned by shareholders. These shareholders elect a board of directors to oversee the organization’s activities. Shareholders are not personally responsible for the actions or finances of the business.
The most common type of corporation is a Limited Liability Company (LLC). This structure treats shareholders like partners in that they have a stake in the company’s profits and losses. However, in an LLC, the profits and losses are taxed on behalf of the company, not the individual shareholders. This tax benefit is attractive to business owners and key to the reason many of them choose this entity type.
C corporations and S corporations are two other ways a corporation can be structured. C corporations are typically companies on an accelerated growth path with multiple classes of stock and foreign shareholders. They have certain tax benefits for offering stock option incentives to employees and reducing capital gains taxes for owners. S corporations are unique for their pass-through tax allowance, which means the company itself does not pay corporate income tax, but instead all shareholders are taxed on the company’s profits and losses. No matter the structure of the corporation, the tax benefits and limited liability implications remain the biggest incentives for incorporation.
What Are the Major Advantages and Disadvantages of Incorporating a Small Business?
The pros and cons of incorporating a business of any size are generally the same. But, in some cases, the advantages may be felt on a smaller scale for a smaller business while the disadvantages may feel larger. For example, a bigger business doing seven figures annually is clearly going to save a lot more on tax deductions by incorporating than a small business barely breaking even. However, the cost of hiring legal counsel to handle the incorporation process might be a drop in the bucket for a large company, while it may present a significant expense to a small business. Still, businesses of all sizes often find the benefits of incorporating to outweigh the drawbacks.
Advantages of Incorporating a Business
Personal asset protection: Incorporating shields your personal wealth from common lawsuit types that may affect your business. It also protects your personal assets from corporate contract claims and business debts you did not personally guarantee. Ensuring your personal estate is guarded no matter the challenges your business might encounter is one of the most powerful advantages of incorporation.
Credibility and name protection: In order to incorporate, you must choose a business name for your articles of incorporation that is not currently in use by any other corporation. This guarantees a level of protection for your company name. Additionally, the “Inc.” or “Corp.” you’ll be able to add to your name following incorporation conveys a sense of stability for your business. Customers, suppliers, creditors, and other partners intone an element of credibility and trustworthiness from these corporate suffixes. This credibility can go a long way when you’re working to grow your business or raise capital.
Perpetual existence: Corporations are an enduring legal structure for businesses. An incorporated company can live indefinitely, regardless of what happens to individual shareholders, directors, or management. Businesses with other structures may experience legal hurdles with the passing of an owner.
Tax flexibility: Different types of corporate structures experience varied tax benefits. Generally, C corporations have the lowest marginal tax rate. S corporation owners do not have to pay self-employment tax, which is similar to the payroll taxes withdrawn from the taxable income of employees. Additionally, each state has varying tax policies. Business owners can decide which tax options work best for their company when incorporating.
Deductible expenses: Corporations are taxed on their profits. Incorporated businesses have the tax benefits of taking deductions for certain approved expenses when filing their corporate income tax. These include salaries and benefits for employees, operating expenses, marketing and advertising costs, and travel fees, among others.
Disadvantages of Incorporating a Business
Formalities: Incorporating a business means that all operations have to be managed and documented very strictly. Certain activities become mandatory, such as corporate audits and annual meetings. A board of directors must be elected to help guide the business in the right direction on behalf of all shareholders. Publishing meeting notes, financial documents like your tax return and bank account statements, and quarterly reports is required. A registered agent is necessary to receive official communications from government bodies. Unincorporated businesses do not have to follow as many legal provisions as a corporation.
Expense: Operating a corporation demands additional expenses that sole proprietorships and partnerships do not. For example, employing a corporate attorney to ensure the company is following business law comes with steep fees. Additional headcount to handle the administrative responsibilities of a corporation is another expense. In some states, corporations may also need to pay other fees by law, like worker’s compensation insurance. These costs may be prohibitive for certain small businesses, especially those owned by a sole proprietor.
State regulations: Each state has its own unique fees, taxes, and requirements for corporations. This adds an additional level of expense and formality to the process of maintaining a corporation beyond the federal regulations.
Relatedly, it’s noteworthy that so many companies choose to incorporate in Delaware. Nearly half of the publicly traded companies in the U.S. are incorporated in Delaware. This is because Delaware offers competitive tax rates compared to other states. Also, its business law is generally favorable toward corporations. Its court system is efficient, and plenty of corporate legal precedent means cases are handled expediently. If you choose incorporating in Delaware but your company is not actually based there, you will need to hire a registered agent service with an address in Delaware.
How To Become Incorporated
There are a handful of ways to become a corporation depending on your company’s budget and resources.
On your own: It is possible to incorporate your business on your own. After deciding on a name, bylaws, a registered agent, a board of directors, and stock allocations, you can draft and file your articles of incorporation with the Secretary of State. You will also need to obtain an Employer Identification Number if you don’t already have one and whatever licenses are necessary in your state.
Online legal service: There are many Internet-based services that can help automate the incorporation process for you. While most are not free, they are generally less expensive than hiring a law firm to handle incorporation. Many of these businesses include registered agent service, accounting reviews, and templates for corporate documents such as meeting minutes and by-laws.
Business lawyer: Hiring an attorney to incorporate your business can be pricey, but it will free up a lot of time for you and ensure every step is done correctly and in the manner that’s most advantageous for your business. A business lawyer can also provide legal advice beyond simply filing paperwork to help your company use the law to its advantage.
Final Word: Why Incorporate?
Creating and maintaining a corporation can be a challenging process, requiring a financial investment and administrative resources. However, many businesses find the process to be worthwhile due to its myriad benefits, including limited liability for personal assets, tax benefits, and enhanced credibility. Depending on the corporate structure you choose and the state in which you decide to incorporate, there may be additional benefits and challenges to weigh. A corporate attorney can provide assistance and guidance as needed.