Are there disadvantages of incorporating? As you know, owning and operating a business can be a complex endeavor. Basic business building and maintenance activities are a lot to handle, but you can alleviate a lot of stress by setting up your business intentionally from the beginning. In the following article, we will explore the options you have as a business owner.
These activities include:
- Product or service creation
- Sales
- Marketing
- Staff management
- and more
Choosing a Business Structure
As a potential business owner, you must decide which type of legal structure is best for your type of business. It is common for business owners to form a separate corporate entity when starting a new business, but is that always the best route to go? If you are wondering if incorporating is the best option for you, let’s explore the subject of choosing a business structure more thoroughly.
What Are My Options?
As you work on forming your business, you will find that you have many different options. There are a lot of choices when choosing a business structure or entity. To make the right decision for your business, some key information is necessary to understand how each type of structure operates.
Here is a list of the four basic types of business structures.
1. Sole Proprietorship
This is the simplest structure and very common for small businesses when they are just starting out. When you choose to list your business as a Sole Proprietorship, you declare that you will be the sole owner and operator of that business. Sole proprietors have complete legal responsibility for all debts and other legal action pertaining to the business.
This means that if something goes wrong or a business debt is owed, you as the sole proprietor will be wholly responsible for resolving the issue. This simplifies the tax situation for the business since all profits from a sole proprietorship are funneled through your personal tax return. As a result, any financial responsibilities or taxes due, rest on your shoulders alone.
One example of when a sole proprietorship would be a viable business structure is in the case of a freelance writer. This business owner works alone on writing projects for business clients. This is the simplest and most cost-effective way to structure a business. It’s a straight-forward structure that minimizes operational overhead and allows you, the sole operator, to maintain a lean, mean business machine.
It’s important to recognize the limitations of this business structure, however. As your business grows, it will outgrow this business structure. This structure carries with it a significant liability to you, so as your business grows and you add employees, it’s time to update the structure of the business to ensure that the liability associated with the business remains with the business.
2. Partnership
Establishing a business with a Partnership structure is most common when two or more people join together. They work as a team to provide a service or product. Each partner shares in the financial responsibility, and also the profits. Learn about four different kinds of partnerships here.
A partnership is similar to a sole proprietorship with the exception being that there is more than one proprietor. A common example of when a partnership structure would be a viable choice is if two friends wanted to open a small business electrical repair company in which the two of them alone would handle the workload.
Just as with the Sole Proprietorship structure, liability belongs to all partners listed on the partnership agreement. It is a joint venture, both financially and legally. As with a sole proprietorship, this structure also carries with it a significant liability. Generally, this liability is acceptable so long as (a) the parties involved trust each other and (b) the agreement is structured properly to protect each party in the event of a dissolution of the partnership.
The dissolution of the partnership is often the most overlooked aspect of the creation of the business. The creation of a partnership, like a marriage, is the easy part. In a legal marriage, the two parties can go to the local courthouse, obtain a marriage certificate, and enter into a legal marriage without much difficulty. In contrast, a divorce can be a long, expensive process. A Partnership is the same way, so it is extremely important to ensure that the parties agree in writing how the partnership should be dissolved in the event that one party wishes to take that step so that all parties are protected and the process can take place with minimal expense to the business and the parties.
3. Limited Liability Company
A limited liability company structure works similarly to a sole proprietorship or partnership. There are a few key differences though. This structure can be an excellent choice for a small business with a few employees or a small business with a more complex operational structure. With some exceptions, the owner(s) are not legally responsible for the business’s financial obligations; this offers better protections for the individual owners against the business liabilities.
For example, an LLC owner who is facing a lawsuit will not be responsible for the associated financial implications. Common exceptions to this would be if the owner personally guaranteed a debt of the business or the owner ignored the corporate formalities necessary to treat the LLC as a separate business entity.
It is essential to keep business and personal matters separate when operating an LLC. If corporate formalities are ignored or the members of an LLC abuse their rights, a court may “pierce the corporate veil”. Piercing the corporate veil is the term used to refer to holding members of an LLC personally liable. This would apply to any debts or lawsuits affecting an LLC and allows a lender or plaintiff in a lawsuit to pursue the business owner(s) individually and potentially obtain a judgment against the business owner(s) personally.
The LLC structure provides some legal protection for business owners and greater flexibility in the size of the business than a Sole Proprietorship or Partnership structure. It helps shield personal assets from being affected by a business failure. The benefits of an LLC make it a popular choice of business structure. An LLC is easily formed, maintenance is simple, and it limits owners’ personal liabilities. The LLC has become the most common business structure for small businesses in Arizona.
4. Corporation
The Corporation is a business structure often chosen by larger businesses. The legal definition of a corporation is that it is a group of people authorized to act as a single entity and recognized as such in law. Larger businesses use this business structure more often. There is greater flexibility afforded by the division of ownership into stock. Owners of that stock are referred to as “shareholders”.
There are different types of corporations. The general overview is roughly the same for all incorporated businesses though. Being an incorporated business means that:
- The officers’ personal assets are protected from a business failure;
- Management of the business is divided between officers, typically appointed by a vote of the shareholders;
- Shareholders’ power is often determined by the “class” of stock the shareholder owns;
- Corporations can continue indefinitely by changing board members, directors, etc.
Incorporation: The Pros and Cons
There are some great benefits to incorporating your business besides the benefits listed above. Incorporating your business means that you have a legal right to sell shares of stock in your company. You can also run your business somewhat anonymously if you aren’t eager to be public about your involvement with the business. However, there are some disadvantages of incorporating that are important to keep in mind when structuring your business.
Incorporating Can Be Costly
It costs more money to establish and maintain a corporation than it does a sole proprietorship, partnership, LLC, or other business structure. According to smallbiztrends.com, there are ~$400 of fees associated with incorporating in Arizona. That doesn’t include attorney fees, which can be quite costly as well. It will be important for you to check the amount of capital you have available to form your business. Incorporating can be financially overwhelming for small businesses or those with little capital.
Establishing a Corporation Involves Much Time and Paperwork
There are many legal documents that need to be filed if you choose to incorporate your business.
Those legal documents include but are not limited to:
- Articles of Incorporation
- Company Bylaws
- Certificates of good standing
- Non-disclosure agreements
- And more
Many business owners find incorporating quite labor intensive. There are many forms, paperwork, and research needed to incorporate.
Corporations are Subject to Stringent Compliance Regulations
Corporations are monitored by the government and subject to the strict laws imposed on corporations. They must be able to prove that they meet all required regulations. They also must complete all required legal documents to remain in compliance.
The legal documents required for sole proprietorships, partnerships, and even LLCs are not as time-consuming. Establishing and maintaining a corporation requires far more documents, and these documents must be maintained and updated as the business grows, adds or changes officers, etc. It can require a fair amount of time on an annual basis to maintain these documents.
Incorporating Your Business Can Mean Double Taxation for You
One of the most prominent disadvantages of incorporation is that company profits are often double taxed.
Corporations are taxed first on their net taxable income. Then business owners are also taxed on any salary or dividends they receive. Therefore, a larger business income and profit are often required to make up for the double taxation on the business profits.
A Business Failure Can Have a Greater Loss Impact
When you are running a sole proprietorship failures hit hard. If the business fails, the primary impact will fall on you and you alone. However, when you are running a corporation the ripple effect of a business failure is much more significant. You (and your fellow shareholders) run the risk of losing money via loss or elimination of stock values. You likely have employees that will lose their jobs and a major source of income for themselves and their families as well. Also, if there is significant debt attributed to your corporation you may face costly legal battles as you work to dissolve the corporation. You will have to ensure you do this in a manner where your creditors get paid.
The Bottom Line: Should I Incorporate My Business?
As you can see, there are many factors to consider before you take the steps to incorporate your business. Fowler St. Clair works closely with businesses of all sizes in their corporate and business law matters. Our team of experienced attorneys focus on a limited suite of practice areas that include Real Estate, Business Law, Civil Litigation, and Estate Planning.
By keeping our focus limited to what we do best, we can provide you with the information and support you need to help make your business the best it can be. We can help to assist you in deciding which type of business structure is best for your business. And we can work with you to create the required documentation needed. This will ensure you have all the necessary procedures covered from a legal standpoint. Having the correct legal documents in place for your business is a vital step for any successful business venture. Remember, an ounce of prevention is worth a pound of cure.
Contact our team of experienced business law attorneys today to find out if incorporation is the best choice for your business.