Lately I've received a lot of questions from entrepreneurs about incorporation. This may be a reflection of the large number of businesses in start-up mode, or it could be a sign that the sole proprietorships formed a few years ago are ready to take the next step to a more formal business structure.
The decision to incorporate is an important one, and one that should be timed in the way that makes the most sense for your business. Incorporating can make a business appear more professional to clients, investors and business partners, but it's not always essential. Before incorporating, you should understand the ways in which it impacts cash management, liability and taxes.
Since there is as much mystique as misinformation about incorporation, here are some facts that should help you decide whether to pursue an "Inc." behind your company's name.
- What is a corporation? A corporation is a legal entity that is separate from the people who own it. By existing on its own, it is viewed as acting separately from its owners when entering into business deals, borrowing money and managing other business-related activities. Its structure includes shareholders, who own the corporation and influence it through elections and votes; directors, who manage its affairs on a macro level; and officers, who handle day-to-day business decisions.
- Why incorporate? In many cases, incorporation provides a level of protection from personal liability for a business. This means your personal assets may be protected if something goes awry.
There are exceptions to this protection, including wrongs that you personally commit, personal guarantees you make to creditors, and laws at the state level that affect your personal liability. In addition, some professions may be found personally liable regardless of whether or not their businesses are incorporated. These include doctors, lawyers and accountants, among others.
- Why not incorporate? A corporation's profits may be taxed twice. The first taxation occurs when the corporation declares its income. The second happens when profits are distributed to shareholders, who then pay tax on these earnings. Pursuing status as an "S corporation" can help to alleviate this double tax. S corporations elect a special tax status with the Internal Revenue Service. Under this arrangement, the business's income is reported on only shareholders' tax returns. To qualify for "S corp." classification, a company must be a U.S. business with one class of stock and fewer than 75 shareholders.
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