Should You Incorporate?
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Most small businesses start off simple. Either a sole proprietor or a
number of business partners pool their resources in order to acquire the
tools necessary for running the business, as well as to seek additional
financing and to solve all of the problems of a start-up business.
Keeping it simple at the early stage helps you in a number of ways.
Advantages of a sole proprietor
A sole proprietorship is the easiest form of business to assemble and
saves you from the paperwork and fees of forming other types of business. You are also not accountable to stockholders or to a board of directors for the operations of your business, and you're better able to withstand the stormy first months or years until your business becomes profitable. You can take whatever actions you need to take without the additional step of getting it vetted by a board of directors, and you're more flexible in terms of shoring up finances with your personal assets.
Since it's difficult to generate investor interest in your business
without a proven earnings record, as well, you may find that even if
you're not interested in remaining a sole proprietorship or partnership
for long, you don't have much in the way of options. For all of these
reasons, it's best to start simply and to allow your business to grow
under your close personal direction.
At some point, however, you'll need to give some thought to the
question of where your business should expand to next. Very often, this
is going to involve changing the basic nature of your business from a sole proprietorship or a small partnership into an actual corporation. When this time comes you should consult an attorney and/or an accountant when making these decisions.
Advantages of incorporating
The advantages of incorporating after a few years of operation outweigh
the disadvantages. Once your business has been around for a while, your
risks start to become greater: even if your business is profitable, you'll want to expand at some point, an act that involves the possibility of losing the profits you've made as well as your initial investment capital.
If you're still a sole proprietorship or a partnership at this point, you run the high risk of having any financial obligations you incur in the event of a business failure default onto your personal finances, or those of your business partners. This means that your business risks become personal risks, and you could end up with substantial personal debts and a wrecked credit history. Not only does this give you a number of immediate financial problems, but you'll also find it more difficult to start another business in the future in order to restore some of your financial losses.
If you incorporate your business, however, all of that personal
liability becomes limited liability, a burden shared by you with your
investors. And in the event of a business failure, investors and
creditors won't be able to touch your individual finances, but only the
company's assets. This is by no means a desirable situation, and with
some skill and intelligence, you can minimize the risks. But if worst
comes to worst, incorporating your business can protect you and allow you
to get back on your financial feet much more quickly than you'd otherwise
be able to do.
Additionally, incorporating your business allows you to gain extra
financing, makes your business appear larger and more prestigious, and may give you a tax break, depending on the laws of the state, province, or country in which your business operates. These advantages can mean the difference between success and failure for an established, expanding
business, and shouldn't be passed up lightly. Once you reach a certain
level of operations, incorporation should be taken seriously as an option.
But how, exactly, should you incorporate your business? You have two
major options: true incorporation, and becoming a limited liability
company (LLC).
Incorporate vs LLC
True incorporation turns your business into a legal individual, rather
than essentially a personal asset. Membership of the corporation is
determined exclusively by stock: whoever holds a controlling interest in
corporate stock effectively controls the corporation. This makes it much
easier to transfer ownership of a corporation through stock sales, and
makes it much easier for the corporation to raise money through offering
stock to potential investors.
Additionally, since the corporation is a legal entity, the corporation
is taxed rather than the individual investors and directors--although all
wages paid by the corporation to those investors and directors will be
taxed as well. And in the event of a business failure, the corporation's
assets will be seized rather than the individuals, providing a strong
incentive for individuals to take the risk of investing without putting
their personal finances at stake.
In the United States, there are two types of corporations: C
corporations and S corporations. C corporations are what we traditionally think of when we think of corporations. S corporations, a comparatively recent development, differ from C corporations largely in the way that they're taxed. Taxes for an S corporation pass onto the individual earnings statements of the investors and directors, while still retaining the division between personal finances and company finances. This allows investors in an S corporation to avoid being taxed twice on the same income: once for corporate earnings and once for personal wages.
Because of this clear tax advantage, it might seem like S corporations
are the obvious choice. However, a business must meet certain
requirements in order to qualify as an S corporation. These requirements
include but are not limited to:
- Must have filed for corporation on the state level
- Maximum 75 shareholders
- All shareholders must be legal US Citizens or residents
- Only 1 class of stock
- No more than 25% of gross income can be from outside investments
In short, S corporations are prevented by law from becoming as large as C corporations can become, and it's far more difficult for an S
corporation than for a C corporation to purchase existing businesses. If
you don't intend to expand your business past a certain point, however,
the tax advantages to be derived from an S corporation make it an
attractive choice.
No matter which type of corporation you choose it's important to be aware of the disadvantages. Foremost among these are the problems
resulting from having a board of directors structure in the first place.
If a large number of investors are buying stock in your business, a larger number of people have a say in how your business is run. This isn't a problem if all of your investors are personally involved in your business, but you could end up with a situation where faraway investors who have zero awareness of your day-to-day operating procedures end up with a controlling interest--which means that they have the power to
substantially change your administration.
If you set up the legal structure of your corporation appropriately,
you can avoid this situation, but it'll take extra time and resources and
put a number of additional pressures on you to remain profitable over
time, pressures which can lead your business down paths that you'd rather
not take. So be careful before incorporating.
A better option for smaller businesses may be to form an LLC. LLCs are a fairly recent development in the business world. Basically, an LLC is a sole proprietorship or partnership with the same limited liability protections enjoyed by corporations. The tax advantages of an LLC are similar to an S corporation or partnership. This allows you to keep your existing business structure and protects you from investor pressures while at the same time protecting you from personal financial trouble in the event of a business failure.
What's the catch? The catch is that although an LLC enjoys the same
limited liability--and to an extent, the same prestige--as a corporation,
LLCs normally can get financing as easily as corporations. This can lead
to problems when earnings get higher, and can become an obstacle to
growth. So the choice between an LLC and a true corporation comes down to a choice between administrative style and how much you're willing to
compromise in order to promote the growth of your business. If you want
to maintain tight control over your business, go the LLC route. But if
you want to expand quickly and have fewer problems with raising capital,
go with either a C or an S corporation.
You can, of course, ignore all of these options and go on as a sole
proprietorship or small partnership forever. And if you don't have
ambitions beyond that--and if you're willing to accept the personal risk
of potential business failure--this may be the best option for you. But
give incorporation some serious thought, whether it's S, C, or LLC
incorporation. Incorporating your business can protect your from the
negative consequences of business, and can be the first major step in
propelling yourself toward business's positive rewards.
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