As your business grows it is likely you will find that you need to grow the structure of the business to meet the demands. Many small businesses start out as a sole proprietorship, meaning you are responsible for everything, but soon with increasing income, partners and the need for more capital you may find it is time to change the legal structure to take advantage of tax savings, liability concerns and the ability to raise capital to expand.
Corporations provide the ability for a business to raise capital through share offerings, to exist as their own entity and reduce the personal liability of its owners and shareholders. In addition, there are tax advantages that come with being a corporation – such as the ability to write off health and benefit plans of employees. It is often said that a corporation has a “life of its own” and as such, can exist well beyond the lifetime of the original owners.
However, there are also downfalls to incorporating: You may find that it results in higher taxes overall despite the increased write-offs; the cost of incorporating a business is considerable, and requires a lot of knowledge and legal planning; a corporation is overseen by both local, state and federal entities, which usually requires increased paperwork and compliancy on all levels.
Corporations generally fall under two distinct types: A “C” Corporation (typical) and a Limited Liability Company (LLC). There is also what is known as a Subchapter S Corporation, though this is strictly a tax election only where the earnings and profits are listed as distributions on a personal tax return.
“C” Corporation
A “C” Corporation is the typical model that most corporations follow. Under this model, stock can be sold in the company to raise capital, and is considered a separate taxable entity. After a corporation is formed it exists infinitely as long as yearly fees are maintained.
To form a corporation, you must file “Articles of Incorporation” with your state government. You must also establish a set of bylaws for your corporation. While bylaws do not have to be filed with the state, they are important because they set out the basic rules that govern the ongoing formalities and decisions of corporate life, such as how and when to hold regular and special meetings of directors and shareholders and the number of votes that are necessary to approve corporate decisions. While this may not seem important at first, its value will come into play when stock is issued outside the ownership of the original owners.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a hybrid of a “C” Corporation and partnerships. It affords the same protections as a “C” Corporation but allows for the pass-through tax structure of partnerships. It is more difficult to setup an LLC, but it is often easier to run one than a corporation.
One of the biggest drawbacks to an LLC is that a court may treat the LLC as an extension of the owner’s personal affairs, rather than as a separate entity. In this case none of the protections afforded a corporation would apply and you would assume all liability. In order to prevent this from happening it is important that you act fairly and legally in all business transactions, keep the business well funded, keep the business funds separate from any personal funds, and create and maintain an operating agreement.
For taxing purposes, an LLC is taxes through the owner’s personal income taxes. The income and expenses of the business are listed as distributions on Schedule C for sole ownership businesses and IRS Form 1065 for businesses with multiple owners.
LLC and “C” Corporations Compared
Similarities
· Both are considered legal entities and are filed with the state government.
· Both provide limited liability protection; the owners are typically not personally responsible for the debts and liabilities of the business. However, the officers can be held personally responsible for their actions – such as failure to withhold and pay employment taxes.
· Both entities have very few ownership restrictions.
Differences
· Taxation:
- The LLC is a pass-through tax entity – this means that the income or loss generated by the business is reflected on the personal income tax return of the owners.
- A “C” Corporation is a separately taxable entity. The profits and losses are taxed directly to the corporation.
· Formalities:
- A “C” Corporation requires that certain formalities be followed. The corporation must hold annual meetings of shareholders and directors each year and meeting minutes must be kept with the corporation’s records.
- A LLC is not required to hold annual meetings; however, it is a good idea to document major decisions of the company for legal purposes.
· Transferability of Interest:
- Transferring stock in a corporation is typically easier than the transfer of ownership with an LLC. A shareholder of a corporation is not required to get approval of the other shareholders before selling stock.
- With an LLC, the usual rule is that the owners must obtain approval of the other owners before ownership can be sold or transferred.
Where to Incorporate
When it comes to incorporating your business you are not restricted to the state you currently reside in. You can incorporate in any of the 50 states. Many people choose to incorporate in their home state where they currently are doing business. Doing so may save you money because corporations are required to register as a "foreign corporation" in each state where they do business outside of their state of incorporation.
However, if your home state has a high corporate income tax or high state incorporation fee it may be wise to incorporate elsewhere. In addition, certain states are more corporation friendly than others (pro-business). They offer added protections and further limit the liability of the corporation when it comes to legal matters, as well as offering less strict laws and regulations on what can and cannot be done within the corporation itself.
Delaware is a popular choice because of its pro-business climate. Over half of the companies listed on the New York Stock Exchange are incorporated in Delaware. Recently, Nevada has also gained popularity due to its pro-business environment and lack of a formal information-sharing agreement with the IRS. In addition, Nevada does not have corporate income taxes.
As you can imagine, states often compete for businesses to incorporate there. Take your time to research the benefits of each, and consult a business lawyer for advice if you are unsure of the advantages or disadvantages of a certain location.
When to Incorporate
There is no set rule or timeline on when you should incorporate, or even if you have to. Often businesses incorporate to take advantage of the limited liability protection as well as the tax advantages offered by being a corporation. However, remember that a corporation requires strict guidelines, procedures and paperwork that can take valuable time and money away from a small business, or one that is just getting started.
Remember, as a corporation there is more items that you can deduct from your taxes, but overall your taxes may increase.
Joaquin Reveron is successful wholesale business consultant. Trainer and wholesale marketing agent for online and offline businesses. Wholesale Video Games is one of the topics discussed at http://www.videogamesmystery.com
