The Importance of Incorporating Your Business

Q: What Are the Advantages of Incorporating My Business?

A: For most business owners, the most important reason to incorporate one’s business is limiting individual liability and protecting one’s personal assets. When a business is incorporated, the business is a separate legal entity from the individual who owns and/or runs the business. The law recognizes the corporation as a person under the law that owns assets and obligations just like an individual. This legal fiction provides a form of asset protection that seeks to protect the business owner’s personal assets (e.g. home, car, personal bank accounts, family farm or lakehouse, etc.) from the business’s creditors, or perhaps even an unhappy or injured customer that tries to sue the company. Provided that the business is properly incorporated, adequately capitalized and/or insured a business owner who has incorporated can shield his or her personal assets from business creditors and lawsuit judgments.

Another big advantage to incorporating one’s business is when it comes to seeking investors for that business. As a corporation, an investor can purchase units or shares in the company thereby owning a percentage of the actual company which is far more attractive to potential investors than simply handing over a check to a sole proprietor of a business who has not yet incorporated.

Q: But if I incorporate won’t it make my taxes more confusing?

A: Generally, no; a Limited Liability Company (LLC) or S Corporation is typically treated as a “pass-through” entity to the individual taxpayer and business owner(s). This means that any business profits earned and distributed to the business owner(s) will simply be reported on that individual’s tax return (i.e. IRS Form 1040). In fact, there are many significant tax advantages to incorporating such as deducting pre-tax business expenses necessary to run and conduct the business.

Q: Are there any drawbacks to incorporating?

A: There are very few drawbacks to incorporating a business. Of course, it is true that the business owner will have to pay a fee to the State of Alabama each year to maintain their corporate entity in good standing with the State of Alabama. The cost, however, is quite small considering the protection an incorporated business provides. One has to ask, is the business expense of a couple of hundred dollars each year paid to the State of Alabama not worth protecting one’s house, bank accounts and other personal assets?

Q: What types of corporations should I consider?

A: There are generally three (3) types of corporate entities that a business owner may consider: (1) Limited Liability Company (LLC); (2) S Corporation, or S-Corp for short; and (3) C Corporation, or C-Corp for short. Small business owners would do well to consider LLCs or S-Corps due to the significant tax advantages they provide over a C-Corporation. Limited Liability Companies and S-Corps work largely in the same manner but there are some differences discussed below—

S-Corporations can aid the business owner in avoiding self-employment taxes and the business pays its employees a “reasonable salary” as defined by industry norms. Many business owners view this as a huge benefit. Unfortunately, the S-Corp does have some drawbacks. One must be a U.S. Citizen or resident to maintain an ownership interest in an S-Corp. The process of incorporating and maintaining the books and corporate form of an S-Corp are far more stringent and formalistic than an LLC. Should a business owner fail to adhere to the corporate requirements of an S-Corp it risks losing its S-Corp status and will be treated as a traditional C-Corp with some additional tax burdens. Additionally, any profits must distributed in strict accordance with the number or percentage of shares held by company shareholders.

While LLCs do not avoid the self-employment tax problem they do offer quite a bit of flexibility to the business owner and potential investors. For starters, you do not have to be a U.S. Citizen or resident to participate in an LLC. You can maintain different classes of stock (called units in an LLC) that provide for various voting rights and ownership interests within the Company. LLCs are also fairly easy and quick to set up and can operate under less rigid standards and guidelines than an S-Corp. LLCs owners should be careful however to ensure they keep their business and personal assets separate to maintain the Company’s corporate identity and preserve the liability protection afforded the business owner by the Company. LLC owners can also make a one-time election to switch, or elect, to be treated as a subchapter S Corporation (i.e. S-Corp). Please note, however, an S-Corp cannot opt to be treated as an LLC at a future date. This election is limited to LLCs opting to be treated as an S-Corp.