The primary reason to incorporate a business is to limit the personal liability of the owners for the liabilities of the business.
Do you have assets? Could you possibly be sued for any business issue? If the answer is "yes" then it's time to think about incorporating.
The process of incorporating includes registering your business with the government, getting a new tax ID number, and operating the business as a separate legal entity. You have to file several forms, pay some fees, and your business becomes a separate legal entity (separate from your personal assets).
What are the benefits?
Primary Benefit = Limited Liability
"Limited Liability" means that the personal assets of the owners (e.g., your home, personal bank accounts, etc.) cannot be reached to settle the obligations of the business. To protect your home, you should also file a Homestead Declaration if that is available in your state.
"Personal liability" continues for certain business obligations such as payment of taxes (e.g., employee payroll withholding and sales taxes). Personal liability can also result if the owners "personally guarantee" obligations of the business such as notes or leases.
Personal liability can also arise if the formalities of the corporate entity are not observed by the owners so that it appears that the corporate entity is merely a "sham."
The decision to establish a legal entity for your business adds cost and complexity. Deciding which type of entity is right for your business depends on your objectives and plans.
S-Corp, C-Corp or LLC?
S-Corps and LLCs (limited liability companies) have "flow through tax treatment" and are attractive for investors or owners who want to use start-up losses to offset earnings from other sources. For instance, earnings from your (or your spouse's) "day job" can be offset by business start-up losses.
S-Corps are a good choice for businesses with a limited number of shareholders and a traditional hierarchical management model (President, Treasurer). S-Corps also have a solid track record in the courts and with the IRS.
C-Corps are a good choice if you need capital for your business. C-Corps are preferred by venture investors because they can have preferred stock. This means that investors have a "preferred position" for dividends, liquidation and merger … with options to convert to common stock and share in the future growth of the business. S-Corps are easily converted to C-Corps by revoking the S-election.
C-Corps are subject to two layers of taxation. This so-called "double tax" taxes profits at the corporate level and taxes dividends (which are not deductible to the corporation) at the shareholder level. The double tax may not be a problem if: profits are to be "plowed back" into the business and not distributed to shareholders; and the exit strategy is a sale of stock or merger, which is not subject to double tax. A sale of C-Corp assets is subject to double tax.
LLCs are increasingly popular for "partnership-like" operations, with peer-to-peer member relations among the owners. LLCs are a good choice for professional service businesses and real estate ventures.
Delaware or Your Home State?
Investors favor incorporating in Delaware because it is considered corporate-friendly. In Delaware, the Secretary of State's office operates more like a business than a government bureaucracy and has one of the most advanced and flexible laws for corporations in the nation.
If you incorporate in Delaware and are doing business in your home state, for example, you will have to hire a registered agent in Delaware and register as a foreign corporation in your home state. This means that you will have to comply with annual filing requirements in both states.
Hence, if you're really a local business and don't expect to have investors or expand to other jurisdictions, incorporating in your home state probably makes more sense.
In conclusion, there are many things to think about in choosing the form for your business:
- What is your liability exposure? (Worst case scenario)
- Can insurance or contracts reduce your exposure?
- How many people are involved?
- Do you plan to raise capital?
- Do you plan to hire employees?
- Will your company lose money in the early years?
- Do you plan to sell your business?
- Will you have more credibility in your target market as a corporation?
Bottom Line
The decision to incorporate your business is one you should make after research and with input from trusted advisors like an attorney who specializes in small businesses, your accountant, and a business insurance specialist. To avoid the pitfalls, it’s important to get good advice.
NOTE: Information provided is intended as a broad, general overview and is not legal advice.
© Copyright, 2009, Jean Sifleet. All rights reserved. Used with permission.
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About This Author:
Jean D. Sifleet, Esq. CPA, is the head of the Business Practice Group of Worcester. For practical information, check out Jean's articles and books which are featured on SmartFast.com.
