5 Reasons to Incorporate
One of the most important decisions a business makes is choosing how it is organized. Incorporation may be wise, but for some, it may be unnecessary. Each business should carefully weigh the benefits and drawbacks of incorporation before choosing. Here are 5 reasons incorporation may be a good choice for you.
A good way to understand a corporation is to imagine it as a separate “person” (with limited rights and privileges). Incorporating a business means creating that corporate “person,” making the business separate from the owner (in a sense, the business “lives” on its own). The corporation actually exists independent of its shareholders/owners and employees. The corporation itself continues to exist in perpetuity until and unless the directors and shareholders decide to dissolve a corporation.
In a sole proprietorship or general partnership, the owner is synonymous with the business – what affects the owner might affect the business. The owner’s personal debt or liability could lead to creditors pursuing the assets of the business regardless of whether or not the debt or liability is related to the business. An owner’s personal bankruptcy can also open up a business’s assets to any creditors the owner or partner is liable to. By incorporating, the personal finances of the owner or partner remain separate from the finances of the corporation, allowing the business to continue without disruption.
Also, prior to incorporation, an owner or partner’s untimely death can mean the dissolution of the business regardless of the wishes of the owner or partner(s). All of this can be avoided simply by incorporating the business as a separate entity.
As much as we like to think that business owners should remain committed to the success of their business, there may be times when an owner or partner needs to get out. One big benefit of incorporation is that it allows transferability of interest from one person to another. Generally, a partner cannot transfer his/her interest to another without the express consent of other partners. If a partner decides to leave the partnership against the will of the other partners, the partnership is automatically dissolved. Incorporating a business removes this limitation and lets shareholders/owners freely transfer their interest to another without the approval or consent of other shareholders.
Some small businesses may see the transferring restrictions as a good thing to help control how a shareholder may transfer his/her interest and to whom. In that case, incorporation allows this flexibility as well. The free transferability of shares is a default rule, but is not mandatory for all incorporated businesses. Businesses can place restrictions on the transferability of certain shares. Incorporation lets the business decide whether or not to take advantage of this option. More importantly, incorporation prevents a minority shareholder from being able to dissolve a business without cause.
One of the greatest benefits of incorporation is that it limits the liability of the shareholders. Any debt or liability against a specific shareholder remains separate from the corporation. The opposite is also true. Debts or liabilities against a corporation don’t open up the shareholders’ assets to creditors. A shareholder’s liability in any corporate debt is limited to what the shareholder invested, unless there is fraud.
In a sole proprietorship or general partnership, the owner(s) and/or general partners are totally liable for any debt or liability against the business. If the business can’t pay the debt, the creditor can go after personal assets of an owner or partner until the debt is met.
In a corporation, a creditor can only go after assets to the extent the shareholder is invested into the corporation. As a result, the corporation can make business decisions without endangering the assets of its shareholders, beyond the level of each shareholder’s investment. Risk is necessary and unavoidable in business. However, anything that minimizes investor risk will make a business more attractive to investors, so the limited liability aspect of business incorporation makes it a huge advantage for most business owners.
4. Reduced Chance of Tax Audit
Sole proprietors are more likely to file an incorrect tax return, as many are self-prepared. They also tend to under-report revenue and over-report deductions. In recent years the IRS has audited a higher percentage of sole proprietor tax filings than corporate filings. In tax year 2012 for example, a Schedule C filer had a 1.2% to 3.4% chance of being audited depending on reported gross receipts. While small corporations (corporations with reported total assets of $10M or less) other than S corps had a 0.7% to 2.6% chance of being audited depending on reported total assets. S corporations had a 0.5% chance of being audited. The data clearly shows that sole proprietors are more likely to be audited.
5. Increased Credibility
Establishing a professional identity helps increase credibility with your customers and sets you apart from competition. Simply put, adding “INC.” or “LLC” after your business name adds credibility and professionalism that goes a long way with many customers.
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