Growing a business is most associated with increased revenues or services. However, entrepreneurs should also consider the appropriate legal structure for their changing needs. Due to low cost and convenience, many startups begin as sole proprietorships or partnerships. While this setup may be suitable for basic operations, your staffing, liability and tax needs may benefit from incorporating.
So, when should you consider incorporating a business?
Below are some factors that could affect your decision:
Hiring employees signifies growth. You are investing in productivity and expanding operations to serve more customers. Despite these positives, you should consider the liability that accompanies hiring a staff.
Elliott Broidy is an entrepreneur known to manage risk with the best legal structure for each venture. Small business owners can also minimize their liability with ongoing review of their structures.
Employees that commit illegal acts or inflict damages on customer property can expose you to lawsuits. As a corporation, you have limited liability to the harmful or unlawful actions of staff. If your employees work alone or with minimal supervision, incorporating can buffer against this risk.
Despite improved protection against lawsuits and other liabilities, corporations face higher taxes. Instead of personal income tax rates as a sole proprietor, you are first taxed at a corporate rate. Need to draw income from the net amount? Personal tax rates are then applied to this distribution, which creates a double tax.
The solution? Forming an S Corporation or Limited Liability Company (LLC) helps avoid this double taxation. Each of these structures is a pass-through entity, meaning income paid from the business is levied at your personal tax rate.
Separate Your Personal and Business Finances
A corporation is a distinct entity that separates your business from personal finances. Many general partners or sole proprietors finance their businesses with personal means or credit cards. If business obligations can’t be met, creditors can pursue individual assets. By incorporating, your estate is better protected against the business failing.
Your Cash Flow
Many startups have basic cash flow models. Revenue is earned and expenses are paid mostly on-demand. When your business grows to include accounts receivable or depreciation expenses, professional accounting may be needed. At this point, some sole proprietors may not have the resources or savvy to prepare their own taxes.
Since SPs blend personal and business taxes, there is more potential to misreport income or deductions. As a result, sole proprietors (SPs) are at higher risk of IRS audits. Although audits are random, incorporation may remove a prime ‘red flag’ for the IRS. Working with a tax professional also provides insight on business strategies that may not be apparent.
Corporations survive if an owner dies or is incapacitated. Conversely, SPs cease to exist if an owner chooses to step aside or passes away. A partnership also dissolves if an owner leaves. This can pose challenges for those who want the business to survive, even if they are no longer involved.
Small business needs are dynamic. Each situation is unique, but liability and taxes are common considerations. Periodic review of your business gives a better perspective on what legal structure is most beneficial. Please consult with a legal professional or CPA as needed.