Do I incorporate my business?

The first things you must decide when your start you business are whom will run your business and what risks will  you will incur  when running the business. Seems easy, yet these are two major decision that will decide the course of your business.

Often, new business owners do not realize the dangers that they face when they start offering products or services to the public. A business that does not incorporate will place its owners in financial jeopardy. If a third party or the government is injured because of the actions of the business, then the owner or each partner of the business will be liable to the third party for damages.

A new business owner should protect himself from liability by forming a legal business entity or purchasing insurance for the business. The danger of not to forming the new business entity and choosing to purchase insurance is that the insurance may not cover all of the liability owed to a third party. For this reason, our firm always advices our clients to form a business entity when they start a new business. The costs incurred in registering a new business entity are significantly cheaper than having to personally defend yourself from liability.

We suggest you either register a corporation or a limited liability company. Both, a corporation or an LLC, protect the owners from liability. Both have advantages and disadvantages, so it is hard to have a set rule which entity is best for you.

A corporation is a legal business entity that shields its owners from personal liability. There are 2 types of legal corporations: 1. S-corporation; and 2. C-corporation. A corporation allows its owners to choose a board of directors that will make major decisions on how the business will be operated and whom will be responsible for the operation of the business, typically the CEO or the President of the corporation. The directors of the business elect the officers of the business and direct the officers of the business on what actions the company should take with regards to the business. The President of the business follows the directors’ mandates and is responsible for the day to day operations of the business. Both, the directors and the officers of the business are responsible for the actions that they take on behalf of the owners. They owe the owners of the business a fiduciary duty to run the company in a reasonable and legal manner.

An S-corporation has advantages and disadvantages. The advantages of an S-corporation are as follows: the owners have limited personal liability for business debts or injuries caused to third parties by the business; owners report their share of corporate profits or loss on their personal tax returns; and owners can use corporate loss to offset their individual income from other sources. The main draw backs of an S-corporation are as follows: the initial cost to form the S-corporation; they require actions of the company to be recorded more frequently than other business entities; the income that the corporation earns must be allocated to owners according to their ownership interest; and owners can only be legal US residents or citizens.

A C-corporation has advantages and disadvantages. The advantages of a C-corporation are as follows: the owners have limited personal liability for business debts or injuries caused to third parties by the business; Fringe benefits can be deducted as business expenses; and corporate profits can be split among owners and corporation, resulting in lower overall tax rate. The main draw backs of a C-corporation are as follows: the initial cost to form the C-corporation; they require actions of the company to be recorded more frequently than other business entities, for shareholder and director resolutions must be recorded, in accordance to the bylaws of the company or as the state law dictates, or the corporation runs the risk of losing the protections afforded to its owners; and the company and the owners shall have to pay separate taxes, double taxation of income may arise if profits are realized by the company.

An LLC has advantages and disadvantages. The advantages of the LLC are as follows: owners have limited personal liability for business debts, even if they participate in management; profits and losses may be allocated differently than ownership interest; and IRS rules allow the entity to be taxed as either a corporation or as a partnership. The main draw backs are as follows: it is generally more expensive to create than a partnership or a corporation; a member’s (owner’s) entire share of LLC profits may be subject to self-employment taxes.

So which entity do you choose? This is not an easy answer and requires a thorough analysis of what each owner’s expectations in the management of the company, the tax benefits to each owner, the business that will be run by the entity, and the need to have third parties invest in the company.

Sole proprietorships, partnerships, and other legal entities were not discussed in this post. The entities not discussed, in some scenarios, may be better business entities to conduct business, for all business ventures require an in depth look at the advantages and disadvantages of the business prior to opening the business.