Why Should I Incorporate?

 

One of the first decisions you will have to make when you choose to start a small business is the choice of its legal form. Most small businesses are organized as sole proprietorships, limited liability companies (LLCs), or S corporations.

Many start-ups prefer to begin as a sole proprietorship because it is quick, simple, does not cost anything to create, and give the owner maximum freedom in making decisions about the business. In addition, the owner of a sole proprietorship can deduct business expenses, including business losses, from his or her own individual income tax.

Why would anyone want to organize a business in any other way? There are several reasons why you might have to consider another form of business, such as an LLC or corporation. First, you might want to have a partner or partners. A more pressing issue, for many business owners, however, is that sole proprietors are held personally liable for any debts or liabilities of their business. If the business accrues a lot of debt, or if a customer or client sues the business and is awarded damages, the owner’s personal assets and credit history will be placed at risk.

Limited liability companies and S corporations avoid these disadvantages. LLCs and corporations are considered persons under the law, separate from their owner or owners. Consequently, debts of a business that is operating as a corporation or LLC must be settled by the business itself, and do not put the owner’s assets or personal property at risk. At the same time, the owner of an LLC or corporation receives many of the same tax advantages that are available to sole proprietors. Income earned and losses incurred by the business pass through the business to the owner or owners, who can then use any business losses to offset other sources of income on their income taxes.

Of course, there are disadvantages as well as advantages to forming a corporation or an LLC. One of the primary disadvantages is that LLCs and corporations can be expensive and cumbersome to create. To incorporate either as an LLC or an S corporation, it will be necessary to file articles of incorporation with a state in which the business has a registered agent. (The business owner or owners can choose what state to incorporate in – it does not have to be the state in which the business has its headquarters or in which the business will be primarily operating.) When an LLC or S corporation is formed, the state of incorporation will charge a fee, and there may also be fees involved in filing annual reports.

What type of company structure will best support your business operations? There is no one right answer to this question. The answer that is right for you will depend on your unique set of business needs. To make a decision, start by answering the questions on this checklist:

·         Will the owners need or want to have limited liability?

·         Will the owners need or want to have the business profits and losses pass through onto their personal income tax returns?

·         Will all the owners be equally actively involved in managing the day-to-day operations of the company?

·         How much capital does the company need?

·         How much capital will the company raise from third parties? Who will these third parties be, and what will they expect in return for their investments? Will the investment take the form of debt or equity capital?

·         How much corporate formality do the owners need or want to have?

·         What types of entity is the business formally eligible to consider?

·         How much flexibility do the owners want or need in terms of how management is structured and how future changes in ownership might be structured?

·         How long is the investment or venture expected to last, and what exit strategy is being offered to potential investors?

Remember, thinking about these questions and planning for the future before you begin the process of incorporation will save you tremendous hassle and aggravation –and expense – later on.

 

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