"When should I incorporate my business?" is a common question asked by small business owners. Many businesses start out as sole proprietorships, but as they begin to experience success and grow, incorporation becomes a hot topic.
CT tip: Technically, only a corporation is incorporated. An LLC is an unincorporated entity. The more accurate terminology is to say that an LLC is formed or organized. However, for simplicity, this article will use the term incorporate to include both corporations and LLCs.
But when is the ideal time to incorporate your business? Below are some key considerations to bear in mind.
1. Incorporate early to reap the benefits
Benefits of incorporating early include the following:
- Presenting a professional image to customers, suppliers, and investors – Becoming a corporation or LLC enhances your credibility and status. As you are trying to establish and build relationships, having the “Inc.” or “LLC” attached to your name gives you an edge when competing for business. Another consideration is to own the web domain in the name of the company.
- Greater ease in obtaining financing and funding – Lenders generally prefer an incorporated business and may hesitate to provide a loan to a sole proprietor. Sole proprietorships are often considered riskier because there is no separation between the owner’s personal assets and the business (meaning the owner can spend his or her money on him or herself instead of the business). And some investors want a share of the business, which cannot be done in a sole proprietorship but can be in a corporation or LLC.
- Possible tax advantages – Incorporating your business may help lower your tax bill, although you should check with your tax advisor. Whether it will or not depends on a number of issues, including the owner’s personal income tax rate, whether the owner will reinvest income, and whether the owner will be drawing a salary.
- Limited liability protection – Operating as a sole proprietorship invites risk. In the eyes of the law, there is no difference between your personal assets and those of your business. If your business incurs debts (if you can’t pay your suppliers or commercial lease, for example) or an accident occurs, then you are personally liable for them. If a corporation or LLC owns the business, that corporation or LLC is liable for its debts, not its shareholders or members.
2. Incorporate before you sign contracts to enjoy limited liability protection
As mentioned above, incorporation can protect your personal wealth from business liabilities. This is true for online businesses as well as brick-and-mortar businesses.
Corporations and LLCs have their own legal existence. The corporation or LLC can sign contracts, borrow and lend money, invest, and own property – all in its own name. The person who owns the corporation or LLC does not have to use his or her personal assets. Creditors can pursue the business assets but generally cannot reach your personal assets.
CT tip: If you sign a contract as a sole proprietor and later incorporate, you are still individually liable on that contract. For that reason, it's generally better to incorporate or form your LLC before signing contracts, leases, franchise and other agreements, etc.
3. Incorporate early to establish business interests among founders
If a business has more than one founder, a clear understanding of ownership interests helps the business grow harmoniously and effectively. In some businesses, the intention is for all the owners to be equal. But in others, the intention is for some owners to have more financial and/or management rights than others. By incorporating early, and setting forth each owner’s financial and management rights in the governing documents, you can prevent any future misunderstandings and keep everyone on the same page regarding who owns what and who is owed what.
If your business owns intellectual property (copyrights, trademark, patents) or other property, incorporating could be an important step in ensuring the business owns that property rather than any individual founder.
4. Incorporate before hiring employees helps to protect your assets
Businesses that have or expect to have employees should incorporate before hiring them. Employers are generally liable for their employee’s actions and mistakes that are taken in the course of their employment. If you run your business as a sole proprietorship, you as an individual are liable and your personal assets are at risk. However, if you have incorporated, the corporation or LLC is the employer and takes on this liability risk.
5. Incorporate before you add partners or co-owners
Another good time to consider forming a corporation or LLC is when a sole proprietor wants to bring in a business partner as a co-owner. General partnerships (which are what are formed when two or more people go into business together without incorporating) have the same disadvantages as sole proprietorships – in particular, personal liability for the business’ debts. In addition to affording liability protection, corporations and LLCs make it easier to tell who owns how much, who has the decision making authority, etc.
6. Are there downsides to incorporating too early?
One downside to forming a corporation or LLC is that it is more expensive than operating as a sole proprietorship. There are fees for incorporating and then annual (or in some states biannual) fees. Also, there are other compliance requirements – such as having to maintain certain records, appoint and maintain a registered agent, file annual reports, hold shareholder meetings, etc., that sole proprietorships do not have to deal with. In addition, if the owner decides to discontinue the business, as a sole proprietorship, the owner just has to stop doing business. Corporations and LLCs have to go through a formal dissolution and winding up process. So, if you are only in the planning stages of starting a business, you may wish to hold off incorporating until you have more concrete plans for important matters such as contract relationships, hiring employees, and taking on partners.
Once you know you’re starting a business, you’ll find that there are many incentives for incorporating earlier in the process. You will be able to sign contracts and other documents in the corporation’s or LLC’s name and take far greater advantage of the limited liability and other benefits incorporation can offer.