One of the most important decisions a business makes is choosing how it is organized. Incorporation may be wise, but for some, it may be unnecessary. Each business should carefully weigh the benefits and drawbacks of incorporation before choosing. The biggest benefits of incorporating are the 3Ls: Life, Liquidity, and Liability.
A good way to understand a corporation is to imagine it as a separate “person” (with limited rights and privileges). Incorporating a business means creating that corporate “person,” making the business separate from the owner (in a sense, the business “lives” on its own). The corporation actually exists independent of its shareholders/owners and employees. The corporation itself continues to exist in perpetuity until and unless the directors and shareholders decide to dissolve a corporation. In a sole proprietorship or general partnership, the owner is synonymous with the business - what affects the owner might affect the business. The owner’s personal debt or liability could lead to creditors to pursuing the assets of the business regardless of whether or not the debt or liability is related to the business. An owner’s personal bankruptcy can also open up a business’s assets to any creditors the owner or partner is liable to. By incorporating, the personal finances of the owner or partner remain separate from the finances of the corporation, allowing the business to continue without disruption. In the event of an owner or partner’s untimely death, the business is generally dissolved regardless of the wishes of the owner or partner(s). All of this can be avoided simply by incorporating the business as a separate entity.
As much as we like to think that business owners should remain committed to the success of their business, there may be times when an owner or partner needs to leave the business. One big benefit of incorporation is that it allows the transferability of interest from one person to another. Generally, a partner cannot transfer his/her interest to another without the express consent of other partners. If a partner decides to leave the partnership against the will of the other partners, the partnership is automatically dissolved. Incorporating a business removes this limitation and lets shareholders/owners freely transfer their interest to another without the approval or consent of other shareholders. Some small businesses may see the transferring restrictions as a good thing to help control how a shareholder may transfer his/her interest and to whom. In that case, incorporation allows this flexibility as well. The free transferability of shares is a default rule, but by is not mandatory for all incorporated businesses. Businesses can place restrictions on the transferability of certain shares. Incorporation lets the business decide whether or not to take advantage of this option. More importantly, incorporation prevents a minority shareholder from being able to dissolve a business without cause.
One of the greatest benefits of incorporation is that it limits the liability of the shareholders. Any debt or liability against a specific shareholder remains separate from the corporation. The opposite is also true. Debts or liabilities against a corporation don’t open up the shareholders' assets to creditors. A shareholder's liability in any corporate debt is limited to what the shareholder invested, unless there is fraud. In a sole proprietorship or general partnership, the owner(s) and/or general partners are totally liable for any debt or liability against the business. If the business can’t pay the debt, the creditor can go after personal assets of an owner or partner until the debt is met. In a corporation, a creditor can only go after assets to the extent the shareholder is invested into the corporation. As a result, the corporation can make business decisions without endangering the assets of its shareholder, beyond the level of each shareholder’s investment. Risk is necessary and unavoidable in business. However, anything that minimizes investor risk will make a business more attractive to investors, so the limited liability aspect of business incorporation makes it a huge advantage for most business owners.
The major detriment to incorporation is taxes. In a sole proprietorship or partnership, taxable income flows directly to the owner and/or partners and is taxed at the individual's income tax level. However, the corporation is considered a separate entity, and therefore its income is taxed first under a corporate tax. If remaining income is distributed to shareholders, that income is taxed again based on the individual's income tax bracket. This is essentially double taxation. The marginal tax rate for a corporation may also be significantly higher than the marginal rate for sole proprietors. Although this characteristic may deter a business from incorporating, double-taxation can be avoided by taking advantage of the options given to a corporation by various states. Two options include incorporating as an S-corporation or filing as a Limited Liability Company (LLC). As an LLC or S-corp, taxable income flows directly to the shareholders/members (without being taxed twice) while maintaining the benefits of incorporation. The 3Ls are important, but they are not the only benefits. There's also a psychological benefit to incorporating that goes beyond the numbers or legal concerns. Incorporation can seem daunting, but it’s an exciting moment in the life of a business. Conceived as an idea, a business is born at the point of incorporation. This psychological step of seeing the business as a real entity will motivate and inspire you to greater achievement.
Reduced Chance of Tax Audit
Sole proprietors are more likely to file an incorrect tax return, as many are self-prepared. They also tend to under-report revenue and over-report deductions. In recent years the IRS has audited a higher percentage of sole proprietor tax filings than corporate filings. In tax year 2006 for example, a Schedule C filer had a 1 in 32 chance of being audited. For non-business filers, the odds were 1 in 124. It clearly shows that sole proprietors are a lot more likely to be audited.
Establishing a professional identity helps increase credibility with your customers and sets you apart from the competition. Most businesses choose to incorporate to reinforce their legitimacy to customers and suppliers. Adding "INC." or "LLC" after your business name adds credibility and professionalism that goes a long way with many customers.
You can certainly file all the necessary incorporation documents yourself. However, when you consider the time involved for filing, administering, and maintaining all of these documents, it makes sense to get help. Let us help you get it done, so you can spend time actually growing and running your business.
- Forming a business with Launch by LegalShield is a cost-effective way to protect personal assets and gain potential tax savings.
- Our incorporation services start at just $145 (plus required government fees).
- Lawyers charge, on average, over $200 per hour. With our document filing services, you'll know exactly what you are getting, and how much it will costs from the very beginning.
With Launch by LegalShield, it’s easy to get incorporated for just $145 + state fees. PLUS, you become a LegalShield member with access to a dedicated law firm. Your law firm is available for unlimited consultations, contract reviews, employment questions and more.