Often, one of the first pieces of advice an entrepreneur receives when they start a business is to incorporate or form a limited liability company (LLC). When you incorporate a business, you are able to select an entity formation that provides structure to the business. This ultimately impacts everything about the company, from how much you pay in taxes to the personal liability you face as the owner.
But, what happens if you choose not to incorporate a business? Can you still run an unincorporated business?
The answer is yes. However, operating and maintaining an unincorporated business comes with a series of problems that can impact you as the owner and the business itself.
Let’s take a look at some of the most common issues facing entrepreneurs that don’t incorporate — and how incorporation can help resolve these problems.
There is no limited liability protection
The default entity formation for businesses starting up is a sole proprietorship. A sole proprietor is an entity that allows the owner to assume responsibility for all aspects of the business. Minimal paperwork is involved when filing and it is inexpensive to form a sole proprietorship. Some entrepreneurs, especially those with few risks facing their business, may choose to keep their business as a sole proprietorship.
However, a sole proprietorship does not offer limited liability protection. Limited liability creates a separation between the assets of the business and the owner. This means that in the event of an unforeseen circumstance, like a lawsuit, it does not impact the personal belongings of the owner. Assets like houses and cars cannot be used as collateral because of limited liability protection.
Which entity formations provide limited liability? Nearly all entities, from limited liability companies (LLCs) to S Corporations, have limited liability in their entity formation. The only one that does not is a sole proprietorship.
If you feel confident that your business can take full responsibility for everything that comes its way as a sole proprietor, you may stay with this entity. However, if you know you need a bit of protection, you may consider incorporating or forming an LLC.
Fewer tax benefits are available
An unincorporated business, like a sole proprietorship, may face challenges when filing taxes. Sole proprietors are responsible for all taxable activity. They must report all income on their tax returns, including self-employment tax and tax on business profits. These numbers add up quickly for sole proprietorships. The end result may be thousands of dollars in taxes, with few options available for lowering the tax bill.
An alternative to this situation is to consider electing an S Corporation filing. An S Corporation is a pass-through entity formation. This means business income, deductions, credits and losses pass through to business owners. The owners report taxable activity of the company on their personal income tax returns, allowing the business to legally avoid double taxation.
An S Corp election also reduces the aforementioned self-employment taxes. Under an S Corp, shareholders are able to act as employees. As such, they receive a salary and dividends. This helps reduce self-employment taxes and the total annual tax liability. A sole proprietor, or any unincorporated business, would be unable to do this unless they file to elect S Corporation tax status.
It becomes harder to establish credibility
Let’s say you’re a customer and you have a choice between shopping at two businesses. The first choice is “Deborah Sweeney, LLC” and the second is “Deborah Sweeney.” Which business, based off the name alone, do you feel would give you a greater sense of security as a customer?
You’d likely chose “Deborah Sweeney, LLC,” or would shop at a similarly named establishment like “Deborah Sweeney, Inc.” Consumers may be wary of shopping at or doing business with an unincorporated business. They are much more likely to do business with a company that has taken the time to properly incorporate or form an LLC. Incorporated businesses help build credibility, name recognition and trust in customers.
In summary, it is still possible to run and operate an unincorporated business. However, an unincorporated business will face more challenges than its incorporated counterparts.
In the long run, the best thing is to stick to the initial advice given to entrepreneurs about incorporating or forming an LLC. This ensures your small business has access to limited liability protection, credibility and tax benefits from day one.