Law Sections

Minimize and Manage Risk

Know Your Options When Incorporating Your Small Business

Michael Gove

Michael Gove

The majority of companies begin as modest businesses owned by a sole proprietor or partnership, and often it is not until the company has grown do owners consider incorporating the venture. Whether small or large, all businesses can benefit from incorporating, but the most basic reason for considering a change in the business structure boils down to managing potential risk.
Incorporation is the act of forming a new legal entity (business structure) that provides certain business, tax, and legal advantages to its owners. The separate legal entity can own property, pay taxes, sign binding contracts, and, most importantly, protect its principals from many types of liability.
When deciding to incorporate, the following advantages should be considered:
• Limitation of Liability: The main advantage to creating a business entity is the limitation of liability faced by principals of the business. If a business is run as a sole proprietorship, the business owner assumes all liability, but when the business is a separate legal entity, an individual principal’s or investor’s liability is limited to the amount he has invested. In contrast, as a sole proprietor, your personal assets can be seized to pay the debts of the business.
• Raising Money Can Be Easier: Business entities can borrow or incur debt and can sell shares, which can make it easier to obtain capital for your business to develop.
• Deductible Expenses: Business entities may be subject to advantageous rules for business expenses.
• Protection of Trade Names: While not conclusive, the registration of your business-entity name with the secretary of state will provide additional protection against another business with an identical or similar name.
• Additional Credibility: A business entity may have more credibility with potential clients.
• Continuation of the Business: A business entity may continue to exist even beyond the death of a principal.
There are a variety of business entities that a business owner may use, and each provides specific legal and tax advantages and disadvantages. These include:
• Sole Proprietor: A sole proprietorship describes a simple business structure that is owned by an individual. Many smaller businesses operate as sole proprietorships; however, as mentioned above, one of the major disadvantages of this structure is that the owner is personally responsible for all legal and financial liabilities. A business-related lawsuit or IRS tax audit can place the owner’s personal assets at risk of seizure. Further, all business income is taxed as personal earned income by the owner. Though an owner may choose to use a trade name (also known as a d/b/a), there is no legal separation of the owner from the business.
• General Partnership: A general partnership allows two or more parties to share in the liability and profits of a company. Those parties can be comprised of corporations, individuals, other partnerships, trusts, or any combination thereof. Advantages of a general partnership include its ease of establishment and its ability to use the financial and managerial strengths of all partners. The disadvantages of a general partnership include the unlimited liability faced by the partners for the legal and financial liabilities of the business; that liability caused or incurred by one partner leaves all partners vulnerable to seizure of business and sometimes personal assets; and that one partner is able to commit the partnership to obligations without approval from the other partners.
• Limited Partnership: The limited partnership (LP) business structure creates a separate legal entity that involves one or more general partners and one or more limited partners. The limited partners typically invest capital in the business and are limited in their liability proportional to the amount of capital they invest. The general partner controls the operation of the partnership and is personally liable for its obligations and debts. (A corporation is often placed in the general-partner position in order to absorb the liability.)
A majority vote of the voting partners, unless specified otherwise by a written agreement, can change who serves as general partner. When a limited partner is sued personally and a judgment is issued, that limited partner’s interest in the limited-partnership entity is protected from seizure, as are any assets held by the limited partnership. Because of this protection, the limited partnership can be effective in shielding assets from creditors.
• Limited-liability Partnership: A limited-liability partnership (LLP) is most often employed in professional practices such as law, accounting, and architecture. This type of separate legal entity allows for liability protection for all general partners, as well as management rights. In most cases, the limited-liability partnership provides for the same limited liability found in a corporation. For tax purposes, the limited-iability partnership is a flow-through entity like a partnership.
• Limited-liability Company: The limited-liability company (LLC) combines the limited-liability benefits of a corporation and the tax benefits of a sole proprietorship (though one can choose to have the LLC taxed as a corporation). In an LLC, the owners are referred to as members. When the LLC is sued, its status as a separate legal entity can protect the individual members from liability. When the members are sued personally, the LLC and its assets are protected from being seized by creditors of the members. Because of these benefits, a limited-liability company is a popular choice of business entity for a wide variety of objectives.
• Corporation: Depending on a number of factors, a corporation can choose to file taxes either as a C corporation (where taxes are paid by the corporation) or as an S corporation (where income is passed through to the owners and is taxed on them individually). A corporation can choose to be an S corporation if it has fewer than 100 shareholders and all shareholders are U.S. residents. As a C corporation, there is no limit on the number of shareholders; additionally, C corporations can deduct employee medical expenses and insurance costs.
Once you have created a business entity, you will also need to request a federal employee identification number (FEIN) from the IRS. With a FEIN, your business will be able to open a bank account. Maintaining the company’s bank account separate from other business or personal accounts is crucial to avoiding a determination that funds have been ‘co-mingled.’ Updates with the secretary of state will be required at least annually, and more often if changes are made. Depending on the type of work being conducted, additional licenses or certificates may be required from the state or municipality where your business operates.
Remember, your business is ever-growing and changing. It is always a good idea to seek the assistance of a responsible tax professional and a qualified business attorney who can offer practical answers to your questions.

Michael S. Gove is an associate with Springfield-based Cooley, Shrair, P.C.; (413) 735-8037; [email protected]

Related Posts