One of the biggest issues a small business owner must face is whether to incorporate, and if so, when. The question is: Why it so important to form a corporation or LLC? And how do you know which legal entity is the right type for your business?
Many people start their businesses as sole proprietors. Often, it is because they aren't really planning their business and just started selling a product or service. Sometimes, they don't want to go to the effort or cost of incorporating until they know if the business is viable. Other times, they don't feel their business is risky enough to need protection.
Imagine you write software and distribute it as shareware—you might think that is as low risk as it gets, right? However, imagine that you inadvertently distribute a virus that destroys data on people's hard drives. Now you may be liable for their lost data. Selling homemade jam at a farmer's market? Seems harmless enough until someone gets food poisoning and blames your preserves. It is important to learn how to protect yourself from the risks faced by your business.
So What Is a Sole Proprietorship?
In a sole proprietorship, the owner of the business and the business are a single entity. Only one person owns the company and instead of paying corporate taxes, the owner pays personal income tax on any profit. This type of business has some advantages because there is less paperwork—for example simpler tax returns—and there are fewer regulations. Make a profit? It is all yours. On the other hand, if there are problems such as lawsuits? Those are all yours, too.
What Is a Corporation? What Is an LLC?
A corporation makes your business a distinct entity. In other words, it separates your business assets from your personal assets. Worried because you are the only person in your company? That is just fine; one person or multiple people can own a corporation. In most cases, if you are considering incorporating your small business, you will want to investigate S corporations. These are corporations especially designed for small businesses. S corporations are not usually required to pay corporate taxes; instead they only pay taxes on dividend earnings. Growing fast? Want to issue stock? A C corporation will allow you to issue stock and set up a board of directors, but you will have to pay corporate taxes.
An LLC, a Limited Liability Company, is a different type of business entity. Like a corporation, an LLC offers protection for the owners' personal assets in the event of lawsuit or debt. The owners—called members when the firm is an LLC—can collect their profits through the company without paying corporate taxes in many states. There is also greater flexibility in how profits can be distributed amongst the owners than in corporate structures.
Advantages of Incorporating
Incorporating protects your personal assets by separating them from those of the business. In the event of a company lawsuit or bankruptcy, your personal assets will not be at risk. LLCs offer similar protections.
So, if you are running a business that is at high risk for being sued or has risky finances and you have personal assets you would like to protect, it is wise to form a corporation or LLC. Of course there are some circumstances in which you can still be liable; you may also want to consider business liability insurance.
Corporations can also save you money in taxes. This savings can be substantial for firms that are realizing large profits.
Reasons to Wait
Suppose you decide you want to convert your business into a corporation or LLC. When is the best time to do it? Generally, since a corporation protects your personal assets, the answer is "as soon as possible." However, if it is very close to the end of the year, you might want to wait until the first of January. Why? If your business operated as both a sole proprietorship and a corporation during the year, you will have to file two tax returns—one for each type of business—and therefore incur additional tax preparation costs.
So, What's Best?
Whether it is best to incorporate or form an LLC depends the type of business you have, the owners, and your financial and business growth goals. An LLC is ended by the death or bankruptcy of a member, where a corporation continues without regard to these events. If you plan to issue shares of your business to other people, a corporation is the better choice.
Ultimately, there is no single solution that works for every type of business. If you feel it may be advantageous to convert your sole proprietorship to a corporation or LLC, consider all the variables and choose the entity type that will be most to your advantage.