Most businesses start out with little money, great expectations, and a willingness to work hard on the part of their owners. With budgets tight and income not yet coming in, each expense is carefully considered and all expenses not vital put aside until more money is available. Given such restrictions, most entrepreneurs put off considering the incorporation of their entity until more money is available, and often years after the business starts. Sometimes the decision is put off indefinitely.
And that is a major mistake. The benefits of incorporation of a business entity are not only of critical importance but are actually of greater import at the dangerous commencement of a business when the odds of insolvency are greatest and the risks of debt the most extreme. While incorporating (or creating a limited liability company) is usually a good idea, it is more likely to be of greater utility at the beginning of your business life.
This article will outline why.
THE FIVE BASIC BENEFITS OF INCORPORATION:
1. Limited Liability
If one incurs a debt, one either pays it in a timely manner or faces litigation which, if resulting in a judgment, can result in attachment of one’s own bank account, real property, or earnings. On the other hand, if a judgment is rendered against a corporation, the judgment is valid only against the corporate assets, NOT against the individual assets of the owners (unless they violated certain corporate procedures allowing piercing the corporate veil) or unless they executed personal guaranties, both discussed in other articles on this web site.
This allows one to engage in the risky business of being an entrepreneur without necessarily risking all that you own if the business fails.
Is that a realistic fear? Most businesses fail in the first three years of their existence. The ability to obtain limited liability and thus limit the risk of the new business venture is considered by many the single greatest advantage of incorporating.
2. Separate taxable entity available
With a corporation one has the option of creating a “new” tax payer, namely the corporation itself. It can often have a different taxable year which allows remarkable tax planning of great use to many individuals. It allows one to determine when to transfer income tax wise to the owners or employees, when to keep the cash in the company to avoid individual taxes, etc.
And if the separate taxable entity is no longer useful, one can elect a method of tax treatment called Subchapter S which allows the corporation’s income or losses, in most circumstances, to be taxed to the individuals directly. One can even alter one’s method of taxation every so often between having the corporation be a separate tax entity (Chapter C) or taxed to the individuals (Subchapter S.) Note that the other limited liability entity often considered by entrepreneurs, the Limited Liability Company, is not a separate taxable entity.
3. Special Tax Benefits Available
Certain very valuable tax benefits, from the 401K Pension Plans to various tax credits, have historically only been made available to the corporate structure and not to individuals. Some, such as the 401K, are far superior in many ways to the IRAs or SEPS plans available to other types of business structures.
4. Good Structures Available for Shared Control
More than most types of structures, corporations allow very flexible but fully enforceable structural planning to be implemented, and such traditional problems as what occurs when one has a minority owner who becomes hostile, or what occurs if an owner dies or becomes disabled are easily handled with such traditional corporate tools as the Buy and Sell Agreement or other types of corporate structural methods. These tools have been tried and tested in the hundred years that corporations have existed, have a long history of success, and can avoid the usual problems that often destroy the sole proprietorship or partnership. Competent legal and tax counsel can easily create a mix of internal structures within a corporation that can handle almost any conceivable problem that can occur to a new business owner and can intermix within a corporation various checks and balances that can assure efficient and fair operation of the business. No other entity has such flexibility in structure combined with a long history of testing the viability of such structures in tens of thousands of instances in the past.
5. Continued Survival of Business Despite Change of Owners
Death, divorce, moving to a new location, or merely an alteration of one’s own plans can wreck havoc on a typical small business. It is important to note, however, that unlike sole proprietorships, the corporation can exist despite change of ownership and quite often the customer need not even know that a change in ownership has occurred. This ability of the company to alter ownership without the company itself appearing to change gives the corporation a life above and beyond that of its owners and explains why all the largest companies are corporations…and why most small companies seek to be corporations as soon as they can.
This also allows the corporation to spin off divisions or assets into other related entities or even sell them and still maintain the core business and the core identity.
THE DOWNSIDE OF INCORPORATION
1. Cost
While California once passed a waiver of the minimum franchise (state income) tax on certain small corporations for the fist year, this benefit can no longer exist in a nearly bankrupt state and there is still a minimum of approximately nine hundred dollar a year tax that must be paid from the second year onward even if no income is achieved. Further, the incorporation process, need for additional accounting books, need for CPA and attorney advice, and need to purchase the corporate minute book, stock certificates, and seal do add up. Even without the minimum franchise tax, expect the cost to incorporate to equal a thousand dollars with perhaps five hundred dollars additional for the CPA fees. (Most law offices, including ours, charge a flat one thousand dollars for this incorporation process but those firms which charge by the hour could result in fees perhaps five hundred dollars above this estimate.) Assuming the minimum franchise tax must be paid in the first year, expect that incorporation will normally cost about two thousand dollars, though half of that are taxes merely being paid in advance.
2. Time
One must have the first meeting of the incorporators and board of directors of the corporation, must learn the basics of how to run it by having meetings with attorneys and CPAs, and, at least once a year, must have meetings of the board of directors and shareholders and keep minutes. Expect the initial incorporation process to take ten to fifteen hours of your time and each year’s process about five hours of your time.
3. Need to open corporate bank account and set up corporate stationary, signage, etc.
To avoid the appearance of not being a corporation (and maintain full limited liability benefits,) it is important to make sure that all third parties are aware of your status, thus adding the words, “Inc.” or “incorporated” to all stationary, invoice, etc. if important. To do otherwise is to risk “piercing the corporate veil.” Setting up separate books, accounts, stationary and the like for the new entity can run into tens of hours of your time and hundreds of dollars in costs.
4. Withholding Taxes
One is an employee of one’s own corporation if one receives a salary even if one is the sole owner and under IRS law, one must therefore withhold taxes as one would with any other employee. While payroll services can easily handle this obligation, it must be remembered that the owners, if receiving a salary, must also go through the full withholding procedure with its added complications and costs.
WEIGHING THE COST BENEFIT
As one client put it, it is seldom that the law allows you to become two people and to use your “other person” for business, structural and tax planning almost at will. While some additional time and some money is required, the usefulness of the corporate structure is probably best attested to by the fact that virtually any large or even medium sized entity adopts the corporate structure. If one looks around the world, one quickly notices that the overwhelming majority of successful people have, without hesitation, elected to use the corporate structure and clearly they would not have done so if the benefits were not worth while.
Certainly anyone with assets they seek to protect or who faces the complexity of multiple ownership should seriously consider the usefulness of the corporate structure and even those businesses which determine that it makes more sense to wait before incorporating should do so the moment the success of their company makes protecting personal assets important.
One wit quipped that the world has only one class of truly first class citizens: the corporation.
And one can incorporate in less than a week, spending less than two thousand dollars and enjoy the benefits for as long as one is in business.
It is probably the best money that a new company can invest to achieve limited risk, a good and proven structure, and a myriad of tax planning advantages. It is almost always a worthwhile decision to incorporate or consider the other limited liability entity, the limited liability company, discussed elsewhere on the website.