Not Incorporating is Risky Business

The U.S. Census Bureau says that in the U.S. in 2007, there were 23M “nonfarm proprietorships,” 3M partnerships, and 5.8M corporations, respectively, as measured by the number of tax returns filed. This means a whopping 4 out of 5 businesses in the US (over 81%) are sole proprietorship or partnerships, lacking a formal corporate structure.

This is an alarming statistic, when one considers just how easy it is to incorporate, especially given the benefits surrounding incorporation.

Incorporating a business means changing the status of your business, so that it becomes its own legal entity. If you are operating a business by yourself without its own legal status, you are said to be operating a sole proprietorship. If you have one or more “partners,” it is said to be a partnership. In general, incorporating your business requires two things: An agreement defining the corporate structure, and the proper paperwork with the state you are in and the IRS.

There are many legal mechanisms for incorporation. By far the most popular are: S-Corp, C-Corp, Limited Liability Corporation (LLC), Limited Liability Partnership (LLP) and Personal Corporation (PC). Each legal mechanism has its own unique benefits, depending on your situation, which we discuss at length in the “Business Formation” category of our blog.

In general, it’s not a good idea to operate your business as a sole proprietorship or partnership, for two reasons. First, you’re not saving as much as you could on taxes. Second, you’re exposing your personal assets to legal and financial liability.

Of all the business leaders I talk to, I find a vast majority (over 90%) haven’t incorporated simply because they “haven’t gotten around to it.” This phrase means a lot of different things, depending on who I’m talking to. Often, it’s simply because the business leader is struggling to meet payroll and/or fulfill orders, and incorporating seems like nothing more than an administrative burden that is pushed off in favor of the needs of the day. Sometimes, I find the business leader hasn’t gotten around to it, because they are avoiding key decisions that would be needed to incorporate. Also, I find business leaders who want to incorporate, but have become overwhelmed with the possibilities and have simply put it off because it gives them a headache.

Whatever the reason, incorporation needs to be a priority. Some of the more important benefits of incorporation include (if handled properly):

Lower taxes

• No “self-employment” tax
• Taxed as a corporation, which is much lower than individual tax rates
• Can deduct business operating losses without limitations
• Most benefits are conferred tax-free (i.e. For example, medical insurance, life insurance, some forms of educational reimbursement, retirement plans, some entertainment, travel and meals, are all considered tax free to the employees and are deductible to the corporation)
• Can shift income between owners and company in ways to minimize income taxes across the board

UPDATE: In 2017, Congress passed the Tax Cuts and Jobs Act of 2017, which significantly altered how companies are taxed. This has created some incentive to consider C-Corporations over LLC’s. We have a blog article that discusses this, entitled Return of the C-Corporation.

Reduce personal liability

• From the debts of the company
• From legal liabilities of the company (i.e. harms your company causes against others, lawsuits, etc)

Durability: The corporation exists, even upon your death or bankruptcy

• As a separate legal entity, the corporation continues to exist even if one or more of the owners passes away
• Personal bankruptcy doesn’t affect the corporation, and visa-versa

These benefits sounds pretty academic, until one considers the benefits of incorporating in light of real-world circumstances. Then, the benefits become overwhelming.

First, consider the tax benefits. As a corporation, it’s often possible to get your tax liability close to zero, depending on your expenses and benefits. Deductions against the revenues you make as a sole proprietorship are subject to many limitations, and therefore create more tax liability for you.

Second, consider the protection against financial and legal liability. If your business goes bankrupt, you are personally protected against financial liability (assuming you have been able to avoid making personal guarantees). Financial liability can come from all sorts of unanticipated directions. Consider the following:

• Suppose you go out of business, but you have another year on the lease of your premises? You may be financially liable for the remainder of the term of your lease agreement.
• Suppose you carry inventory? Your vendor or supplier may not accept returns, or if they do, they will charge you some form of “restocking” fee. This would be a financial liability.
• Suppose you had employees, some of whom you let go and they collected unemployment insurance? That unemployment insurance would continue as a financial liability.
• Suppose you had a 401(k) program for employees, with a “safe-harbor” contribution? Next year’s safe-harbor contribution would be a financial liability.

These are just some of the many possibilities that crop up, when considering financial liability. A sole proprietorship exposes you to these sorts of financial liability.

The legal liabilities are even worse, and can come from all sorts of unanticipated directions. Consider some of these hypothetical scenarios:

• Someone slips-and-falls outside your storefront, and they sue you and your landlord
• One of your employees goes haywire, and hurts a customer – physically, or steals from a customer, or stalks a customer
• Through no fault of your own, your product or service fails or doesn’t deliver to expectations
• Some form of negligence (i.e. your employees got too busy, and made a mistake) causes an injury
• You are sued for $5M, but your general liability insurance has a cap of only $2M, and you don’t have an umbrella policy
• One of your employees gets upset at you, and sues you for some form of harassment

Legal liabilities create financial liabilities, but they are much worse, because they cannot always be foreseen and the potential liability they create can be unlimited. For sole proprietorships and partnerships, a legal liability can be so great, that the assets (and insurance) of the business cannot absorb the hit. When this happens, your personal assets, including your home, bank accounts, retirement accounts, etc, are at risk. In fact, many plaintiffs attorneys will automatically sue business owners individually, aside from the business itself, in an attempt to grab as many assets as possible in a lawsuit.

Incorporating makes this much more difficult for plaintiffs attorneys, although not impossible. Incorporating properly helps improve the odds that a lawsuit cannot “pierce the corporate veil” and attach to your personal assets and property. Read more about personal asset protection here.

Third and finally, consider protecting your family upon your death. Durability of a corporation helps ensure this. If you give yourself a heart attack, working your long hours day-after-day, your family will have the power to continue the business without interruption. In a sole proprietorship, the business dies when you die. It’s assets immediately fall into the estate. In a partnership, if you don’t have a partnership agreement in place, this becomes a HUGE headache for your partner and your estate. Incorporating addresses many of these problems.

In summary

For the small cost associated with incorporating, in comparison to the benefits, it just doesn’t make sense to put it off. The tax benefits, with the protection from financial and legal liability, should make incorporating your number one priority if you are a sole proprietorship or partnership.

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Law 4 Small Business (L4SB). A little law now can save a lot later.