One of the most common questions I am asked by people who have just started a business is whether they should incorporate. The decision to form a business entity is a complex and an entrepreneur would be well served to consult their personal attorney and accountant before making such a critical decision.
Many articles addressing this topic are full of scare tactics and exaggerations, usually aimed at terrifying people into purchasing an incorporation package sold by the article author.
In order to try to introduce some sanity into this realm, I will address various factors and considerations you should take into account when making the decision whether to incorporate.
Disclaimer: Though I am a lawyer in real life, and do not play one on TV, the information below is not intended as legal advice and should not be taken as such. Legal issues related to incorporation are important, complex, and should be tailored to each individual company. If you are thinking of incorporating a business, please contact a lawyer for a personal consultation. If you happen to be in Illinois, feel free to contact me and I will refer you to a lawyer focusing his practice in this area. Otherwise, please contact your local bar (bar association, not tavern!) or ask other business owners for recommendations.
Many people refer to creating a business entity as incorporation. Technically, incorporation only refers to forming a corporation, which is different than forming the other principal business entity in existence, the limited liability company (LLC). For purposes of this article, the term “incorporate” will be used to refer to forming a business entity, whether a LLC or corporation.
Currently there are six principal manners in which a business can be operated. Those six business organizations are C-Corporations, S-Corporations, LLCs, Limited Partnerships, General Partnerships and Sole Proprietorships.
C-Corporations, S-Corporations and LLCs are considered business entities. That is, they have an existence and are treated as persons separate and apart from their shareholders or members.
Limited Partnerships, General Partnerships and Sole Proprietorships have no existence separate from their owners. They are not legally distinct.
The differences between the individual entities above will be discussed in a future article. Today, the discussion will be focused on the factors an entrepreneur should consider when deciding whether to form a legally distinct entity to operate his business.
Factors to consider when deciding to incorporate:
Insulation from liability: Corporations and LLCs afford shareholders and members limited liability. Limited liability means that the business owner is only liable for the debts of the business to the extent that the shareholder has a stake in the business. Limited liability protects the business owner from creditors with debts originating both for contractual obligations and torts (such as injuries to others). Limited liability protects the personal assets of the owner from creditors. Though limited liability is greatly touted, and is a powerful incentive for forming a limited liability entity, it is not absolute.
For small businesses, insulation from debts from contractual obligations almost never exists because lenders require personal guarantees from borrowers. The personal guarantees allow the lender to come after the shareholder personally if the business defaults on a debt.
Protection from torts is also problematic. The first line of defense against tort liability is a robust liability insurance policy. Liability insurance will both pay a judgment as well as provide lawyers to defend you. Without insurance the cost of legal defense alone could bankrupt a business, even if it wins.
Relying solely on limited liability for torts is dangerous due to two potential pitfalls. First, if your actions directly injure someone, the lawyer representing the injured person will sue you individually as well as suing your business. Whether this tactic succeeds depends on the facts and the applicable state law. The other possible pitfall is that if the limited liability entity has not been respected as a separate entity relative to finances, bookkeeping, corporate formalities, ect. the limited liability entity may be disregarded. If the entity is disregarded, the owner’s personal assets are at stake. For these reasons, it is important to have sufficient insurance from a reputable company.
Lastly, if your business has co-owners, or employees, it is almost certain that a limited liability entity should be carefully considered. Without a limited liability entity, you can be held responsible for the debts incurred by the business due to the actions of your co-owners and employees. Limited liability entities do a good job of protecting your personal assets from the debts of others.
Burden of corporate formalities: The second factor to consider is the considerable paperwork burden imposed by forming an entity. While the burden is less with regard to a LLC as opposed to a corporation, it is still significant. In order to prevent a court from disregarding your entity, you need to make sure to treat the entity as independent and also comply with state and federal law respecting filings and records.
An entity needs to draft and file the originating document, whether that be articles of incorporation or articles of organization. Bank accounts must be set up in the name of the entity and be funded from shareholders contributions. Bylaws or operating agreements must be written, stock must be issued. Both a board of directors and officers must be selected and the board must meet, vote, and keep minutes. A register of shareholders must be kept and powers must be formally bestowed. Failure to carry out these tasks could result in the entity being disregarded, dissolved or regulated by default state laws.
Costs associated with forming and maintaining an entity: In addition to costs associated with the burdens above, most states impose filing fees and taxes on an entity when it is formed along with an annual report fee. Moreover, an entity requires its own accounting and tax returns and a lawyer will likely have to draft some of the documents required to create and operate an entity.
Tax considerations: Unfortunately, the tax code influences far to many business decisions, and this is one of them. Various business organizations are taxed differently. Income from non-entities is attributed directly to the owner as is income from most LLCs and S-Corporations. C-Corporations have their income taxed twice, once at the corporate level and once when that income is passed to shareholders. Generally, though not always, the double taxation makes C-Corporations undesirable for small businesses.
Perpetual life: Unlike humans, business entities can live forever. A sole proprietorship ceases to exist when the owner dies and the same is true of partnerships that do not take proper precautions. The ability to have your business survive you is an important benefit of having a business entity.
Multiple owner issues: Though partnership agreements can account for many issues which come up when there are multiple owners, having a formal entity makes everything cleaner and reduces the risk of chaos if the owners decide they don’t like each other anymore.
Sale: If you intend to sell your business, having an entity is a tremendous advantage. Selling an entity is infinitely easier than selling a business that is literally you.
Outside funding: The only form of outside funding typically available to non-entities is debt financing from banks and everyone knows that business loans from banks are currently few and far between. Equity investors are seldom willing to deal with a non-entity. Anyone who wants to raise capital for their business should make use of an entity.
Credibility: Though perhaps illogical, some customers and many vendors prefer to deal with an entity. Having an entity makes the business seem more legitimate and the owner more serious. Some owners also report a felling of prestige as a result of owning “a real business.”
Health insurance: Lastly, corporate rates on group health plans are often favorable. If you need health insurance for yourself and employees, consider the advantages an entity offers.
There are many factors that go into the important decision whether or not to form a business entity. If you choose to form an entity, you can do the work yourself (likely through the secretary of state in your state) or use a service such as LegalZoom. I have no experience with LegalZoom, but Pat at SmartPassiveIncome used the service.
I hope this guide has been informative, and please be sure to consult with your lawyer and accountant before making a final decision.
Because the purpose of this blog is to take my readers along with me on my journey towards a second income, in my next post I will discuss whether I formed a business entity and what led me to my decision.