Three Little Letters That Can Protect Your Business
Climbing your way to success often isn't easy. Learn how incorporating your business can help minimize your risk.
When Cindy Edwards realized her lifelong dream of opening her own
business, it didn’t take her long to decide how to organize it. After
only four years as a partnership, By His Design, her Internet website
design and development company in Jacksonville, North Carolina, became
a limited liability corporation in 2004.
“We wanted to solidify the rules and roles of the partners and provide a step of protection between business assets and personal assets,” Edwards said. “I don’t have a large legal staff. We are small and I just don’t have the resources where I could take on a huge legal battle and provide the protection that I needed for my business.”
She also found the process of incorporating to be a rather simple process. “We hired an attorney and he did most of the paperwork. We just had to make a few decisions regarding our articles of operation and possible contingencies of the future.”
Edwards’ story is no isolated case. In today’s business environment, it’s more important than ever to protect yourself and your personal assets by incorporating your small business. More than two million new businesses are incorporated in the United States each year. Unfortunately, the true value of incorporating a business is often not seen until the business faces a negative situation such as a lawsuit or bankruptcy.
The first step to incorporating is deciding which form of business structure makes the most sense for your situation: the C corporation, the S corporation, or the limited liability corporation. The C corporation, the most common, provides the greatest flexibility for shielding profits from taxes. However, a double-tax situation may arise when the shareholder pays his own income tax. S corporations are equally well-established and have the advantage of “pass-through” taxation: the corporation does not pay taxes on profit. Instead, the profit is allocated as income to the individual owners. The LLC (Limited Liability Corporation) is very similar to the S corporation but less well-recognized.When choosing the right structure, there are many important things you need to consider such as taxes, plans for raising capital, administrative tasks, and how much you envision the company growing, according to Karl Roth, managing partner with the Roth Law Group, LLC in Chicago. Before deciding on which corporate structure best suits the needs of their clients, the Roth Law Group considers the following: the need to limit the liability of the owners; the size, scope, and type of business; startup costs, including licensing and other fees; existing capital and the need for outside investors; state licensing and tax requirements; and the time commitment necessary to handle regulations and formalities.
“When choosing the right structure,” Roth said, “the most important thing to consider is how large you envision your company growing. If it is going to be a small operation and you don’t plan on raising capital, you’ll want to go with a smaller structure.”
Roth added that if you need to change over to a different structure, it is a fairly straightforward process. However, there are certain rules to be aware of. One such rule is that not all businesses can operate as LLCs. Businesses in the banking, trust, and insurance industries are typically prohibited from forming an LLC. Some states have their own restrictions on who can form an LLC. In California, for instance, architects, accountants, lawyers, doctors, and other licensed healthcare workers are prohibited from forming an LLC.
There are many advantages to incorporating your small business, but few are so important as limited liability. Once incorporated, individual owners or shareholders cannot be held responsible for the actions of the corporation. Since the corporation is a separate legal entity, the owners can conduct business without risking their homes or other personal assets. Therefore, the owners or shareholders cannot be sued for any claims against the corporation. In the event of a business failure, the corporation’s bankruptcy cannot be held against the individual owners or shareholders. Their liability will be limited to their investment in the corporation. Note that these protections will only be in effect if the business is maintained as a separate legal entity complying with the corporation laws of the state in which the business was incorporated. Sole proprietorships and general partnerships do not have the same protection from liability. In those cases, the owners and the business are legally the same. Therefore, any debts or liabilities incurred are the responsibility of the owners and all of their assets are available to satisfy these obligations.There are also many tax advantages to becoming a corporation. In many cases, corporations are taxed at a lower rate than individuals. In some states, such as Delaware and Nevada, there is no state income tax on corporations. In addition, corporations have fewer restrictions than sole proprietorships or partnerships in dealing with losses. Corporations can routinely carry operating or capital losses back three years and forward 15 years. Finally, once incorporated, the difficulty of documenting and proving the legitimacy of business deductions is reduced. Expenses that previously raised a red flag resulting in a tax audit are now more likely seen
as a normal business transaction.
By incorporating, your business will also benefit from lower payroll taxes. Corporate profits are not subject to self-employment taxes, such as Social Security, Medicare, or workers’ compensation tax deductions. These taxes will only apply to the money actually paid out in salaries. If not incorporated, these taxes will apply to all profit. Corporations are also allowed to deduct 100 percent of premiums paid for employee health insurance, including the previous individual owners. The formation of a 401(k) savings plan and other available pre-tax benefits (for example, health care and dependent care expense accounts) could result in additional savings. These benefits are not subject to tax withholdings and thus reduce both the corporate tax share and the owner/employee tax share. Tax liability can be further reduced by the corporation matching employee deductions with any of the above. Note that if a business is not incorporated, employees are limited to a $2,000 IRA and no expense accounts. Finally, the corporation can deduct payments for life insurance, automobile insurance, and educational expenses that unincorporated individuals cannot.
A softer, but no less important, reason to incorporate is the legitimacy that it lends to your business. Cindy Edwards, for example, added that becoming an LLC has helped her to establish more credibility with her clients. “They see those letters and they know that this is a real business,” she said. In fact, there are some companies that will only do business with corporations. Even individual buyers may be prejudiced in favor of the company with “Inc.” or “LLC” after their name.
The CostThere are typically four types of costs for forming a simple corporation: filing fees with the secretary of state, first year franchise tax payments, various governmental filings, and attorney fees. Filing fees with the secretary of state generally cost from $45 to $300. Each state requires a fee along with the incorporation papers. The
filing fee may be set or based on the number of shares authorized. Sometimes it’s a combination of both. The highest filing fee of $300 is charged by Texas, followed by Alaska’s fee of $250.
First year franchise tax prepayment will typically run from $800 to $1,000. A franchise tax is the fee paid for the privilege of doing business in a state. Some states, such as Nevada, do not charge a franchise tax as an incentive for businesses. Various additional governmental filings will be $50 to $200. Two factors will determine the types of governmental filings for your corporation: the type of business and the state of incorporation.
Attorney fees will cost from $500 to $5,000. These are the fees that can vary the most when you incorporate. They depend on several factors, such as whether you are incorporating a simple corporation; whether you incorporate in the state in which your corporation conducts the majority of its business, whether the corporation can qualify for exemptions from federal and state securities laws, and whether your corporation is involved in a heavily regulated type of business.
For entrepreneurs like Edwards, incorporating a business is part of a vision not merely of what the company is, but of what it could become and where it will take the people involved. “If one of the partners were to become ill or decide that they want to quit, it is very important to have measures in place,” she said. “You need to be aware of things like who will get the first buyout option or if their children will inherit their portion of the business.”
Above all, Edwards finds it best to be prepared: “We wanted to make sure that we had things in place for the future.”