If you’re a business owner, you’ve probably thought about incorporating. After all, incorporating means you can build a stronger business, enjoy a whole host of tax benefits, and protect your personal assets. But how do you know which entity type to choose? What are the differences? And is it smart for you to incorporate your business in the first place? Here’s what you need to know.
Am I Required to Incorporate My Business?
Many times, the decision about whether to incorporate is made for the business owner. An entity must incorporate if designated in any form other than a sole proprietorship or general partnerships.
What is a Sole Proprietorship?
The IRS defines a Sole Proprietorship as an unincorporated business owned by one person. Sole proprietorships are not required to incorporate.
What is a General Partnership?
A general partnership exists when two or more persons agree to conduct business with one another, and to be personally liable for any legal-or-debt-based obligations the company may face. General proprietorships are not required to incorporate.
Which entities must incorporate?
The most common entities subject to incorporation are corporations (in any form), limited liability companies (“LLCs”) and limited liability partnerships (“LLPs”) or limited partnerships (“LPs”). However, there are certainly more. All entities other than sole proprietorships and general partnerships must incorporate, including cooperative associations, and nonprofit companies.
Choosing Between an LLC, Corporation or Sole Proprietorship
Assuming one person owns an entity, that owner can typically choose between incorporating as an LLC, Corporation, or Sole Proprietor. Here are the benefits of each:LLCAn LLC is commonly preferred amongst entrepreneurs. It has the liability protections of a corporation while not requiring double-taxation or self-employment tax. Moreover, as it is a much newer type of entity than a corporation, there are fewer state and federal requirements as to how the owner must run it. You can browse each state’s requirements for forming an LLC here.
A Corporation is more respected by investors than an LLC, and is certainly much more respected than an unincorporated entity. It also offers a clear tax-shield. Moreover, if an entity qualifies to be an S-Corporation (fewer than 100 shareholders, no foreign shareholders, all shareholders must be individuals, only one class of stock, and not an ineligible corporation), it may offer tax advantages similar to an LLC. A C-Corporation is the most heavily taxed entity, but it is the best shielded for purposes of shareholder liability, and it is most likely to encourage investors to become shareholders in the entity.
A sole proprietorship is best when an entity has no need to incorporate. In other words, if an entity is not worried about liability or attracting shareholders, a sole proprietorship may make the most sense. However, even if so, an owner should be aware of the self-employment tax incurred by sole proprietors. To explain, the self-employment tax is used to substitute for taxes required of incorporated entities. Hence, taxation for a sole proprietor is similar to taxation for an LLC or S-Corporation, and is preferred over a C-Corporation as far as taxation is concerned.
If you want to form a partnership, the next step is to decide whether to incorporate as an LLP, LP, or whether to remain unincorporated as a general partnership. The main difference is that an LLP offers liability protections where a general partnership does not. In other words, in the case of a general partnership, if “Partner A” breaks a law or contract, “Partner B” can be held personally liable for “Partner A’s” indiscretions. In the case of an LLP, “Partner B” likely could not be held personally liable under these same facts. For this reason alone, entrepreneurs greatly favor incorporating a partnership to prevent being held personally liable over remaining a general partnership. Keep in mind that these are just basic guidelines. Deciding whether or not to incorporate is an important decision, and it’s always best to speak to a business lawyer before making a decision.