One of the most important decisions a small business owner can make is choosing their company’s legal structure. Entrepreneurs often launch their companies as sole proprietorships with no legal separation between them and their businesses. They may avoid incorporating because they think it is a difficult, time-consuming process or because they believe it’s unnecessary for a small business.
Although you certainly are not required to incorporate, not doing so means that your business may miss out on the benefits. Structuring your small business as an S corporation or a Limited Liability Company (LLC) provides advantages that will impact your personal liability, how much you pay in taxes, and your ability to raise or borrow money.
Here are five things to consider when choosing whether or not to incorporate your business:
1 – Personal Asset Protection
Business owners often form a legal business structure to separate and safeguard their personal assets. In a properly structured and managed corporation or LLC, owners should have limited liability for business debts and obligations. This means you can conduct business without worrying about losing your home, car, or personal savings because debts or legal judgments are only claimed against the business.
2 – Potential Tax Benefits
When it comes to paying taxes, S corporations and LLCs are attractive options for small business owners. Each offers tax benefits and deductions that aren’t available to individuals.
For example, an LLC is taxed at the same rate as a sole proprietorship while providing limited exposure to personal liability. All profits and losses are passed through the business to each member of the LLC. Members report profits and losses on their personal federal tax returns just like the owners of a sole proprietorship.
Structuring your business as an S corporation also provides liability protection and profits and losses can pass through to your personal tax return. Many sole proprietors choose to incorporate as a way to lower their self-employment taxes. Only the wages of the shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.
In addition, some expenses that shareholder/employees incur can be written off as business expenses. Individual circumstances vary, so be sure to consult with a CPA or tax advisor about your own particular tax situation.
3 – Greater Credibility
Adding “LLC” or “Inc.” after your company name can add legitimacy and give your business credibility a boost. Customers, vendors, and partners often prefer to do business with an incorporated company, and in some industries a formal business structure is required to bid for contracts. In addition, many larger companies are more comfortable outsourcing projects or services to an incorporated business versus a sole proprietor.
Most states prohibit another business from forming an entity or using a trade name that is the same as your incorporated company name. This benefits your business legally and helps in establishing and marketing your brand.
4 – Business Credit
Owners in sole proprietorships or partnerships need to sign contracts in their own name, which means they must rely on personal credit and assets to apply for credit cards, a loan, or a line of credit to grow their companies. However, once you form an LLC or corporation, the business begins to establish its own financial profile.
If you anticipate substantial financing needs for your business, now or in the not-so-distant future, make it a priority to establish credit and apply for loans and financing in your business’s name. Once you establish a solid credit history, your company will be able to borrow on its own merit.
5 – Access to Funding
Setting up a formal business structure is essential if you are looking for funding. When a third party wants to invest in your business, there needs to be an organized entity set up to accept the investment. Banks and other lenders are also hesitant to provide funding to sole proprietors because of the perceived risk when it comes to repayment. Summit Financial Resources requires prospective clients to provide proof that they are incorporated and in good standing with the state in which they are established.
Corporate status also allows business owners to take on co-owners or issue stock by selling ownership shares. Many entrepreneurs choose to grant stock options in order to attract top talent or to compensate employees, vendors, or contractors. In addition, venture capitalists and other investors typically prefer to work with corporations since they allow for different classes of stock.
Which Structure is Right for Your Business?
Over 70 percent of U.S. businesses are owned by sole proprietors and operate successfully without incorporating. However, if you need to protect personal assets or apply for financing to grow your business, incorporation might be ideal.
S Corporations and LLC s are popular forms of incorporation for small businesses. Each offers liability protection and pass-through income tax treatment for business owners, but there are significant differences between the two. When weighing your options, the U.S. Small Business Administration (SBA) advises you to consider key issues including the number of owners involved, what you can and cannot write-off for tax purposes, the amount of employment tax you may be required to pay, and individual state tax laws.
Selecting the right type of structure for your business is not a decision to be entered into without seeking expert advice from professionals. Your attorney or accountant can help you determine which entity is the best fit for maximizing your financial and operational success.
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