I get a lot of questions about incorporation, how to and why, as well as venture capital and funding. I thought I would touch on the highlights of organizing a business and why.
Why Organize Your Business or Incorporate
Personally I like to embark only on tasks that make sense and are done for a reason. Therefore instead of just incorporating for the sake of doing it, let’s discuss why first. If you begin to operate a business, meaning you are incurring expenses and hopefully generating revenue, then you are officially in business. There are three main areas of concern: debts, liability and taxes. While a debt is typically considered a liability I am splitting it into financial debts and legal liabilities.
By default you are a Sole Proprietor and while nothing needs to be done you may not want this particular classification and here is why. As a sole proprietor you are personally liable for the debts of the business.
If you were to obtain a loan with the business it would be obtained under your social security number and you would be personally liable if there were ever an issue. A common example, because you would be surprised how many do this, you may rent office space under your own name. The lease may be a 5 year lease and you have only yourself, two years later you have 10 employees and have increased the space. An issue comes up and the bill cannot be paid for some reason, maybe you took on a partner and they stole some money, now the landlord can come after you personally. You have put your personal assets and potentially your family at risk. As an aside I have known individuals to have incorporated but still sign personally for leases, they had their reasons but there are alternatives, they did not have to – a topic for another post.
If there is ever a lawsuit relating to the business, as a sole proprietor you have again put your personal assets at risk.
You will only be taxed once, there are other issues but this is the most important to keep this review brief.
I will touch on this briefly, but essentially there are: general partnerships and limited partnerships. As a general partner you will both be personally liable. Limited partners can invest in the business but “limit” their risk and exposure to the amount of money they invested. There are reasons for this structure, however for now I will focus on the more common below.
The first thing to note is that as a corporation it is it’s own entity, a separate legal entity. Without getting into two many details, if done properly the business owners will avoid taking on liability for the debts and only the business will be accountable for the legal liabilities. However there is double taxation. The business is taxed and then the income that is paid to you is taxed on your personal return – hence the “double” taxation. Therefore you have probably heard of “C” and “S” corporations. Electing to be an “S” corporation with the IRS allows you to have your income flow through to you and not be taxed twice while maintaining the other debt and legal liability protections of a C corporation.
LLC’s have become more popular over time. The acronym stands for Limited Liability Company. An LLC provides the best of all worlds with the debts associated to the company, the legal liabilities associated with the company and you are effectively taxed once.
It should be said that every situation calls for a potentially different structure. There are also other issues such as the issuance of stock and how they are governed which may dictate one legal entity over another. However that being said it seems to be more popular these days for individuals to use LLCs as the entity of choice. There is also typically less paperwork and in some cases lower yearly fees for LLCs.
There is also the issue of choosing which state to incorporate in. Many choose their own state, depending on where they are doing business. Others choose states such as Delaware for their long history of case law and feeling of general certainty as how they would rule in various instances, others choose based on state tax and/or privacy.
* As a caveat I need to point out that this is not legal advice and there are exceptions to every scenario outlined above.