When is the right time to incorporate?
Many small business owners come to us and ask when and why they should incorporate. There are a number of things to consider before making that decision. Do you have assets that could be exposed to creditors? Do you own equipment? Real estate? What business expenses will you incur? Do you have employees?
The first step in answering the incorporation question is to understand some differences in the legal entities. Generally speaking, small businesses fall into three main categories: Sole proprietors, Partnerships and Limited Liability Companies (LLCs.)
• Sole Proprietors are businesses owned and operated by a person where there is no legal distinction between the owner and business.
• A Partnership is similar to a sole proprietor, but consists of two or more individuals who share in the profits and losses of the business. Sole proprietors and Partnerships for taxation purposes are known as pass-through entities. The profits and losses are reported directly on the owner’s personal tax returns.
• LLCs combine the pass-through taxation of a sole proprietor/partnership with the limited liability of a corporation.
There are a number of advantages an LLC has over a Sole Proprietorship and Partnerships. The main advantage is that owners are typically not personally liable for company debts, meaning that once the LLC’s funds are exhausted, creditors can’t go after the owners unless the owner was required to sign a personal guarantee. Secondly, it’s much easier to raise money with an LLC since it can sell membership interests. Also, ownership transfers can generally be sold to third parties without business interruption. Finally, if you have employees, an LLC offers an additional level of protection.
There are couple of disadvantages to incorporating, mainly the cost to setup, which is more expensive than a sole proprietorship or partnership. A formal organization is required, so that means more paper work! Also, separate accounting records are required, so keeping personal affairs separate is key. Depending on the size of your business, you might need to hire bookkeeper, accountant, or CPA to assist with maintaining the books.
If you choose to incorporate, you may also need to consider making an S election with the IRS. Depending on your profit levels, it can provide you with some much-needed tax advantages, but it also requires owners to be paid through payroll instead of with owners’ draws which adds a level of administrative time and expense.
Are you confused yet? Here is an example that might help. John works full time at ABC Company. On the side, he does work for XYZ Company given his expertise in his field. No additional equipment or resources are necessary for him to do his free-lance work. John probably does not need to incorporate given no assets and no risk. The following year, John realizes this side job could generate significant profits and leaves his employer to go out on his own. He purchases equipment, buys property, leasing a portion of the property and hires an assistant. He would probably want to incorporate given the assets (property and equipment) and risk (lessor, employees.)
If you are facing this decision, give us a call! We would love to help you make the best decision for your business and give you peace of mind.