Many small businesses begin as a sole proprietorship or a partnership between friends or business associates. It is usually an easier way to get a business up and running. Yet as your business grows: incurring debt, acquiring assets, taking on employees and an increased potential for liability, a business owner should give serious consideration to incorporating. Incorporating your business can provide certain advantages and protections such as limited liability, tax advantages, easier access to capital, and employee benefits.
However, each business is unique and presents its own set of circumstances. Owners should evaluate the advantages coupled with disadvantages of incorporating as each owner strives to make their business successful.
Sole Proprietorship
A sole proprietorship is an easy entity to establish legally. Basic minimal steps usually involve registering a fictitious business name in place of your individual name (dba statement) and getting a business license within your locality. As the business grows the sole proprietor must take into consideration the business owner is personally liable for the business debt, taxes, and other liabilities. For example, if you begin to take on employees, you personally may expose yourself to increased liability and possible litigation through non-compliance with labor laws, through vicarious liability for wrongful actions of any employee, and personal injury lawsuits.
Partnerships
Where there are two or more owners of a business, people can simply agree to form a partnership. Again, this is an easy entity to establish. No actual written agreement between the co-owners is required to start the business. However, most states have basic rules and laws partnerships must follow, such as equal division of profits and losses among partners (unless spelled out differently in a written agreement). It is always prudent for any partnership to therefore create a written agreement, commonly known as an operating agreement, which will spell out the terms of the partnership. Like the sole proprietorship, similar circumstances arise and questions of personal liability, tax consequences and other issues present themselves causing owners to seek the legal protections provided by incorporating.
Decision Time
Thus, the main reason business owners choose to incorporate or form an LLC is increased exposure to personal liability as the business grows and to take certain tax advantages. When deciding to incorporate it is best to do some research and consult both an experienced attorney and tax advisor. There are several types of corporate structures to choose from such as Profit or Non-Profit corporations, Professional corporations, Close corporations, S-corporation, Limited Liability Companies and so on. Depending upon the type of business, your business model could have advantages and disadvantages. If you have already established a business as a sole proprietorship or partnership before incorporating you will want to consult with an experienced attorney and tax advisor to assure proper classification of business assets, function of the corporation, tax consequences, and compliance with corporate laws, which if not followed properly can have costly consequences.
Advantages to Incorporating
Limited Liability: A corporation provides protection to its shareholders who have a vested stake in the corporation’s success. The owners of the business (shareholders) may not be personally liable for many of the corporation’s business debts, claims and other liabilities. Therefore, as a shareholder who invests in a corporation you generally only stand to lose the amount of money or the value of the property which you originally invested. If for whatever reason your business fails, as a corporation, creditors of the business cannot typically seize the corporate investor’s home, car, and other personal assets.
However, there are pitfalls an owner must be aware of when forming a corporation. Incorporators may be liable for contracts signed or agreed upon prior to becoming incorporated. A business owner should be careful in making personal guaranties to obtain loans for the corporation. The shareholders may be liable if the corporation defaults on that loan. Additionally, if your business, even as a corporation, fails to pay income, payroll, or other taxes, both the state tax board and the IRS are likely to try to recover the unpaid taxes from responsible employees. This often refers to the principal directors, officers, and shareholders of the corporation. Any attempt to use the corporation to defraud third parties will also expose shareholders to liability. Finally, state law imposes some basic requirements on corporations and failure to follow the laws could expose your personal liability.
Dual Taxation: Setting up a corporation can allow the owners to take advantage of lower tax rates. The corporation is a taxpayer, with its own income tax rates and tax returns separate from the tax rates and returns of the owners. This can allow corporate profits to be kept in the business and taxed at the corporate taxed rates, which is typically lower than tax rates for the owners. Evaluated and structured properly the corporation and its owners often strive to achieve overall tax savings.
Yet, for the small business owner who wants to incorporate, a nice benefit of the business is to be able to write off business expenses on your own individual tax returns. The lawmakers understand this and have provided corporate structures which allow for pass-through taxation, which functions as the standard tax treatment one would get as a sole proprietorship. Therefore, if it is advantageous to you individually, a person may choose to form an S-corporation which allows pass-through taxation of all business profits to the owners. An S-Corporation has all its profits, losses, credits, and deductions passed through to its shareholders, which can then be reported on the owners’ individual tax returns.
Owners as Employees: For a sole proprietorship you earn money when the business makes a profit. Under the corporate structure there is the advantage in business owners can work as an employee of the corporation and pay yourself a salary. It also means you can become eligible for tax-deductible corporate fringe benefits, not available to you as a sole proprietorship. The corporation can establish pension plans, medical reimbursement, life insurance, and more. These benefits under a sole proprietorship would have to be reported as income on your tax returns.
Access to Capital: A corporate structure can be beneficial in raising money for your business. Often incorporated businesses have an easier time obtaining loans from banks and other lending firms. This is attributed to the organizational structure of the corporation. Also, a corporation may make it easier for friends, family and business associates to invest capital, as a corporation is designed to accommodate capital interests, allowing you to issue stock in a variety of forms and declare dividends.
Limited Liability Companies (LLCs)
LLCs have been around in California since the early 1990’s. Many small business owners who have a joint venture with friends or business associates are attracted to LLCs. The reasons are simple, the LLC allows owners to pay business taxes on their individual income tax returns like partners, but also gives the legal protection of personal liability for business debts and judgments as if they had formed a corporation (Please note, pass-through taxation is also allowed under the S-Corporation as well).
An LLC also provides flexibility in structure and management. The key component for an LLC is its operating agreement, which will define how the LLC will be owned, how profits and losses will be divided, how members will be bought out, etc. For example, LLC owners can split profits disproportionately to their ownership interests, where this cannot be done with an S-Corporation. LLC members may be able to personally deduct more business loses on their tax returns each year than an S-Corporation’s shareholders.
Yet not everyone can form an LLC. Licensed professionals such as doctors, lawyers, architects, etc. cannot form a Professional LLC under California Law. (Consult an experienced attorney or contact the Secretary of State to determine if your licensed profession is restricted from forming an LLC.)
Conclusion
Setting up your corporate structure can be a relatively simple process with minimal filings through the Secretary of State. However, when incorporating there are many nuances to the law and certain advantages and disadvantages to how you structure your business to maximize your personal asset protection and tax liabilities. Be sure to consult experienced attorneys and tax advisors so you can successfully grow your business. Protect your assets and get going!
This article appeared in the March 10, 2008, issue of the San Diego Business Journal
For more information about this topic, please contact one of our business attorneys at 619.238.1712.
