One of the most important decisions you’ll face when you start your own business is how to organize it. There are benefits and challenges involved in each type of business model, and here we’ll look in-depth into one of the most popular solutions: incorporation.
It may help you understand what a corporation is if you think of it as an artificial person. By incorporating a company, you separate the business from its owners. Regardless of what happens to the employees, the shareholders, the directors, or anyone else involved, the corporation continues to exist in perpetuity. It only ceases to exist if the directors and shareholders make a decision to dissolve it.
In a sole proprietorship or general partnership, anything that affects the owner may affect the business. Personal debt or liability of an owner allows creditors to pursue the assets of the business, whether or not the debt involved the business at all. Similarly, bankruptcy of an owner will directly hinder the business. Upon the death of a business owner, the company is usually dissolved, sometimes against the wishes of surviving partners. If the business is incorporated, these issues can be avoided and the business can continue without disruption.
Sometimes a business owner realizes that they need to step away from their company and give their responsibilities and assets to another person. In a partnership, generally a partner cannot transfer his or her interests without the consent of all other partners. If a partner decides to leave a partnership against the others’ wishes, the partnership automatically dissolves. Incorporation allows for the transfer of interest from one person to another without the usual unanimous consent of all other shareholders. A small business may want to maintain the ability to determine when and where transfers occur, and incorporation allows for this option too. But the incorporation can also protect the business from being dissolved if a minority shareholder decides to leave without cause.
One of the most beneficial aspects of incorporation is limited liability against the shareholders. Similar to the way a shareholder’s debts do not transfer to the incorporated business, any financial distress of the corporation does not transfer to the shareholders. If an incorporated business is unable to pay a debt, the creditors cannot attack the assets of the owners or partners. The only liability a shareholder has from a failing business is what they have invested into the company. Although risk is a necessary part of any successful business, anything that minimizes the risk to investors makes the business more attractive.
A major downside of incorporation is the change in how taxes are handled for the business. In a sole proprietorship or partnership, the taxable income of the business flows directly to the owners and is taxed based on their personal income bracket. Since a corporation is considered an individual entity, the income is taxed first under a corporate tax. Money that is then distributed within the company undergoes a second tax based on personal income brackets. The marginal tax rate for a corporation can be significantly higher than that of a sole proprietorship. However, small businesses can avoid this double taxation with a few options. Incorporating as an S-corporation or filing as a Limited Liability Company (LLC) allows the income to flow directly to the shareholders without being taxed twice.
On the other hand, incorporating has been shown to reduce you likelihood of being audited by the IRS. Since sole proprietors are more likely to file their tax returns incorrectly, in the recent years the IRS has began scrutinizing such filings more closely. It is important to be very careful when filing your taxes, and as a corporation, you most likely need to hire professional help for the process to ensure that everything is filed correctly.
One of the benefits of incorporating is more psychological in nature. By adding INC or LLC to a company name, it gives the idea of permanence, credibility, and stability to the business. This can help motivate and the people working for the company, and also assure clients and customers of the quality and professionalism to be expected from the business.
Why Should I Incorporate My Business? The legal team at Hathaway Law can help you decide if incorporating is the right step for your business, and can also help make sure every step of the process is done correctly and efficiently. Call today!