Picking a business structure is usually the first big decision for any new business owner. My own companies have helped tens of thousands small businesses get started with an LLC or corporation — and as such, I’ve heard countless reasons why business owners think they should (or shouldn’t) incorporate. There are some common misconceptions associated with incorporation, often related to trying to avoid state taxes or any liability.
To help new business owners better understand the benefits and limitations of corporations and LLCs, here’s an overview of some of the key facts, divided into three main areas: liability protection, taxes, and formality.
Liability Protection: Putting Separation Between the Business Owner and the Business
One of the main reasons for a small business to incorporate or form an LLC is to help protect the personal assets of the business owner(s) from anything that happens in the business. For example, if the business should be sued or can’t pay its debts, the “corporate shield” of a corporation or LLC helps protect the owner’s personal assets from the settlement or debts.
Some business owners mistakenly think that they’re absolved of all personal responsibility once they incorporate or form an LLC; however, this isn’t the case. As an example, let’s say you’re the business owner of an LLC and you perform some kind of work for the business. Unfortunately, you’re negligent in the course of doing this work and your negligence causes damages and someone decides to sue. You might still be personally liable, because the damages were a result of your own personal actions.
Here’s where it’s important to understand the difference between a tort and contractual lawsuit. An LLC or corporation can protect you from personal liability for contractual lawsuits (e.g. your business doesn’t hold up its end of a deal) but not against tort lawsuits (e.g. your personal actions cause the damages). This is why it’s smart to get a good insurance policy if you’ll be performing work yourself.
The other key detail to know is that if your business employs contractors or employees, the corporate shield of a corporation or LLC will protect you from personal liability against things that your employees might do. This is why it can be critical to incorporate/form an LLC if anyone else works in your business.
The bottom line? Incorporating or forming an LLC is a crucial step for protecting your personal assets. However, it’s not ‘bullet proof’ protection, particularly if you’re actively working in the business. You’re responsible for your own actions.
Taxes: State Taxes, Self-employment Taxes, and More
Small business owners usually have taxes on their mind when they consider incorporating. Some think they can incorporate in a low-tax or no-tax state to avoid paying state income taxes altogether. Others are looking to lower what they pay in self-employment taxes while working as a self-employed professional.
Here are some of the key things to know when it comes to taxes and corporations/LLCs. First, for state income taxes, it doesn’t actually matter where the business is incorporated; it matters where you conduct business. So, if you live and run a business in California, you’ll need to pay state taxes on income earned in California- even if your business is incorporated in Nevada.
Forming an LLC or corporation does give you some flexibility in how your business is taxed – and this might work in your favor. For example, if you elect S Corporation treatment for your corporation or LLC, you may be able to lower what you pay in self-employment taxes by dividing your income into salary and dividends (note: you should work with a tax advisor for this). In addition, corporations and LLCs often qualify for additional tax benefits and deductions that aren’t available to individuals and sole proprietors.
Formality — Settling Potential Disagreements Among Owners
Whenever a business has more than one owner, there’s always a chance that a disagreement will arise — no matter how close the owners may be. Without a formal agreement, there can be misunderstandings about how much of the business each founder owns or what to do should one owner want to leave the business.
When you incorporate the company and issue stocks, you’ll prevent these kinds of misunderstandings and have a formal procedure for transferring ownership. Even if you don’t incorporate and choose to form an LLC instead (where you don’t issue stock), the LLC’s Operating Agreement can help formalize your business’ governance and ensure everyone is on the same page.
The bottom line? Incorporating or forming an LLC lays the proper legal foundation and is an important step for any company. Just be sure you understand the details: it should never be considered an easy way to avoid taxes or taking responsibility for your own actions.
LLC/Corp. Illustration via Shutterstock
More in: Incorporation