Small business owners often incorporate in order to protect their personal assets from being garnished during a lawsuit. Although this is the primary advantage of incorporation, there are several other important considerations, both positive and negative. There are three different ways for incorporating a small business: C corporation, limited liability company (LLC), and S corporation.
A C corporation is the most common type of incorporation for businesses who are trying to attract venture capital from investors. There can be an unlimited number of individual shareholders in this entity. Many investors hold the belief that it is the most professional kind of corporate entity. However, they must abide by a host of formal requirements that sole proprietorships are not bound by. These requirements include holding regular meetings of a board of directors, establishing corporate bylaws, and creating formal paperwork detailing the operations of the corporation. In addition, they are taxed individually, so the owners must pay corporate taxes in addition to personal income taxes.
A limited liability company (LLC) is a fairly new type of corporation where corporate profits are distributed according to the agreement amongst the members instead of the number of shares owned. Owners of an LLC must pay tax only on their personal income, and do not have to pay corporate taxes. Also, there is no upper limit on the number of members, and anyone can be an owner, even people who are not U.S. citizens. However, it cannot issue stock or become a public corporation, and owners may be required to pay self-employment taxes.
An S corporation is a mixed bag combining elements of both a C corporation and an LLC. Profits are distributed based on the ownership of the corporation, and partners involved in an S corporation are taxed only on their personal income, and do not have to pay corporate taxes. However, they are limited to only 100 shareholders, and each of them has to be a citizen of the United States.
Recent statistics have shown that only about half of the self-employed people in the United States have incorporated their businesses. But many economists feel that even with small businesses, a corporation has a higher rate of success than a sole proprietorship. Academic research has shown that the former has increased profitability, sales growth, employment rates, and other advantages over the latter. The biggest advantage lies in protecting legal liability. If a sole proprietor is sued, personal assets can be recovered, but a corporation will be liable for only the assets the owners have put in.
Some small business owners feel that their business is not significant enough for them to worry about legal liabilities. Many of them may indeed not be good candidates for incorporation because doing so can be complex and expensive. But for businesses such as e-commerce, shipping products around the globe can cause legal problems that may be more costly and complex than incorporation itself. And where it used to cost thousands of dollars and require a lawyer's help over the course of a couple of weeks, businesses can now go online and get themselves incorporated in a matter of hours for only a few hundred dollars.
The default option for many such owners is not to incorporate and run as a sole proprietorship simply because it is more convenient. There are no legal hoops to jump through and things are easier at tax time every year. But before automatically discounting this option, every business owner should at least look into the possibilities, weigh the pros and cons, and decide whether or not it is a good idea.