Whether you’re launching a brand new business or have been running a small business for years, the beginning of January is always a time to evaluate your business strategies and future direction. One important consideration is if the new year is the right time to incorporate your business. If you’ve been wondering about incorporating or forming an LLC (Limited Liability Company), here’s a primer on incorporation to help determine if 2017 is the year for you to take this important legal step.
Is it Time to Incorporate?
Anyone can legally start and run a business without incorporating. In this case, you’re operating either as a sole proprietor (one owner) or general partnership (more than one owner). These structures are the simplest and lowest cost to set up and manage … which begs the question: why should I bother incorporating my business?
The key reason to incorporate (or form an LLC) is to separate yourself from the business and help minimize your personal liability. When you own a sole proprietorship or general partnership, there’s no distinction between you and the business. If your business is sued or can’t pay its debts, you will be personally liable. Furthermore, with a general partnership, you can even be personally liable to cover something your business partner did.
When you form a corporation or LLC, your business now exists as its own entity, separate from you. This means that your business is liable for its debts, and not necessarily you personally. If you have any concerns about personal liability — for example if you want to protect your personal assets or if you could potentially be sued by a client, contractor or vendor — then forming a corporation or LLC can give you peace of mind that you’re not putting your savings and other assets at risk with your business venture.
There are other reasons to incorporate/form an LLC as well. For example, some clients require that they work with an official business entity (like a corporation or LLC), so you may find yourself needing to incorporate in order to win business. Incorporating also adds a layer of privacy, since you don’t need to use your personal name and home address to represent your business.
And, in what is typically the most compelling reason for small business owners, corporations and LLCs can give you more flexibility when it comes to your taxes. For example, you may be able to lower what you pay in self-employment taxes. You should talk to your CPA or tax advisor for advice on your personal situation.
What is the Right Business Structure to Pick?
If you have decided that you’re ready to create a formal business structure, the next step is to pick the structure type. The two most common entities are the corporation and LLC:
The LLC is a very popular choice for small businesses. This is because it limits the personal liability of the owner(s), while also requiring minimal business formalities and paperwork. As an LLC, you’re typically required to file a simple annual report with the state and keep your personal and business finances separate — but that’s basically the extent of your corporate formalities.
By contrast, a corporation needs to create a board of directors, hold an annual shareholder meeting, and create a formal record (meeting minutes) for any important decision. This can be too much formality for some small business owners.
Another difference between the corporation and LLC is how the two business structures are taxed. By default, an LLC has pass-through taxation; this means that the business itself doesn’t pay taxes on its profits. Instead, any profits or losses are passed on to the owner’s personal tax return. So, if you’re the sole owner of an LLC, you’ll report all the business’ profits on your personal return. Or if you share ownership, you might report 50 percent or 33 percent of the profits (this is based on your LLC’s operating agreement).
By default, a corporation does not have pass-through taxation. In this case, the business needs to pay taxes on any profits, and then owners are also taxed when any profits are distributed to them. This means that if you’re looking to put your small business profits into your own pocket, you may end up being taxed twice: first at the corporate level and then personally. However, a corporation can elect S Corporation tax treatment with the IRS; here, the profits and losses will be passed through to your personal tax return like with an LLC. But you’ll still be stuck with all the administrative formalities of a corporation.
The main reason to form a corporation over an LLC is if you are looking for an outside investor, like Venture Capital. Or, in some cases, a tax advisor may recommend a Corporation — for example, in situations where you want to keep money in the business.
Whether you choose to form an LLC or corporation, the start of a new year is the perfect time to formalize your business structure. You’ll be laying the legal foundation to grow your business in the coming years, while also protecting your personal assets.
Corporate Seal Photo via Shutterstock