To incorporate, or not? It’s a perennial topic that has plenty of surrounding myths. As with so many things, there isn’t one right answer. Entrepreneurs, especially those who work solo, have choices.
There are three main types of corporate organization in the United States: sole proprietorship, partnership and corporation. There are nuances based on federal taxation, state laws and the type of business you have.
A sole proprietor is the easiest to set up. You simply start doing business, and then put your income and expenses on Schedule C of your federal tax return. (Some municipalities require sole proprietors to have a business license). This works well for a lot of people who are self-employed.
There’s one big problem with a sole proprietorship, though: personal liability. The owner’s personal assets are on the line if the business is found to be negligent. If a corporation is found to be negligent, then the corporation’s assets can be lost, but not the assets of the corporation’s owners. This is especially important if the work being done has the potential to harm someone’s life or property.
Incorporation (more precisely, forming a C Corporation) does not protect you from the cost and hassle of defending a lawsuit, though. The liability protection comes into play only if the plaintiff wins a judgement. Even then, some courts have found justification for going after owners if they suspect fraud or gross negligence. Incorporation is no substitute for running a company well and having adequate risk-management procedures.
Many people point to the tax benefits of incorporating, and there may be some. Proprietorship income is taxed at personal rates. Corporate tax rates may be lower on a state level, although the Feds charge corporations more. However, you can shelter some of your income by taking a paycheck from the corporation that is less than its total income. This is deductible from corporate taxes. You can then take other money out of the business through a dividend, which is likely taxed at a lower tax rate and is not subject to payroll taxes.
However, incorporation comes with higher expenses: the initial filing fee, annual renewal fees, tax preparation fees for both the business and the owner and payroll preparation. For some businesses, these costs will be more than offset by tax savings and risk reduction. For others, incorporation is penny wise and pound foolish.
Partnerships sit in between sole proprietorships and corporations. These are formed by two or more people declaring themselves to be in business. They split income and expenses evenly for tax purposes, and they split the liability as well. That ends up being a huge risk, because each partner is dependent upon the others to protect personal assets. The joint responsibility puts an enormous toll on human relationships.
There are two alternatives that can help: the Limited Liability Company, or LLC, and the S Corporation. With an LLC, the business is registered with the state as a separate entity. Liability is limited to the assets of the business, but the reporting and paperwork are simpler than with a full corporation. S-Corporations are similar, but have a larger number of owners. With both, owners report their proportionate shares of the business’ income and expenses on their personal tax returns.
Into this mix is another type of corporation, the B Corporation. B stands for Benefit. A B Corporation’s bylaws call for it to consider the public benefit as well as profitability when making decisions. This gives the board of directors more flexibility. The taxation of a B Corporation is the same as for a C Corporation, but there are additional reporting requirements related to how the public benefit requirements have been met. This is appealing to customers and employees. Thirty states allow for companies to register this way.
There’s also a new type of LLC available in many states, the L3C: Low-Profit Limited Liability Company. An L3C is structured the same as an LLC, but the corporate charter calls for it to operate without a profit motive. These are designed for hybrid charity and business ventures, such as job training programs or low-income housing. Charitable foundations are allowed to invest in these as part of their mandate to place at least five percent of their assets to charitable purposes each year. The appeal here is that an L3C is more flexible than a non-profit but can attract shareholders that are interested in its mission.
Each startup owner has to decide which form is best for its circumstances. There is no one right answer, and entrepreneurs should be suspicious of anyone who says there is one. The key is to think about the mission, risks and potential of the company. Then, you can choose the structure that fits your specific situation.