Is it necessary to incorporate your business?

September 18, 2013

If you currently own or are thinking about starting a business, you have probably heard people talk about the benefits of incorporation. But you may be wondering: is it necessary?

The short answer is no. You can run your business as a sole proprietorship without filing Articles of Incorporation. However, while there is generally no legal requirement for you to incorporate your business, there are many benefits of doing so.

Advantages of incorporation

Two of the most frequently sought benefits of incorporating a business involve limiting tax obligations and personal exposure to liability. When a company is operated as a sole proprietorship, the owner may be held liable for debts or other liabilities incurred in the course of doing business. By becoming incorporated, a business owner creates a separate legal entity, which ensures he or she will not be held personally responsible for covering the company's financial obligations.

Incorporating also provides flexibility, as ownership of a business can be transferred or restructured more easily once the company is recognized as an independent entity under the law. Additionally, incorporating is a key prerequisite for selling stock through an initial public offering (IPO), which can be an important revenue stream for a growing company.

Once you have decided to incorporate your business, there are still a number of decisions that need to be made, including what type of entity to form.

Common types of corporations

Different types of corporations provide different benefits to their owners. The "C" corporation is generally considered the most basic type. C corps can have any number of shareholders, whose personal assets are protected from liabilities incurred by the company. Income generated by C corps is taxed at the applicable corporate tax rate and profits distributed to shareholders are then taxed at the appropriate personal income tax rates.

After incorporating, a business can file to be designated as an "S" corporation, which brings a number of benefits but also causes the company to become subject to several restrictions. These include limits on the number of shareholders, as well as the types of people and organizations that can own stock in the company.

The primary benefit associated with gaining S status is that it allows a corporation's owners to avoid the "double taxation" that occurs with C corps. Earnings are "passed through" the business directly to its owners and are only taxed as personal income.

Not all businesses are eligible to file for S election. Insurance companies, domestic international sales corporations and certain financial institutions are prohibited. To ensure that no unnecessary tax obligations are incurred, companies that intend to be designated under subchapter S should file the appropriate paperwork within 75 days of becoming incorporated.

Another popular choice is the limited liability company (LLC). Like the entities mentioned above, this insulates the personal assets of owners—referred to as "members"—from liabilities incurred by the business.

LLCs are eligible for the same type of "pass through" taxation that is allowed for S corps, although they can also be taxed according to different standards, depending on what is most beneficial. LLCs must indicate how they would prefer to be taxed at the time they apply for an employer identification number (EIN).

First steps on the road to incorporation

While the incorporation process is relatively straightforward, it is important for business owners to ensure that they are making sound decisions that will lay a strong foundation for future success. Before filing Articles of Incorporation, business owners may want to seek advice from an accountant or attorney.

Once they are prepared to take the next step, working with an experienced provider of incorporation services can help ensure that the process runs smoothly.

Tomorrow, this blog will follow up with a look at some of the reasons why people often choose to incorporate their business in Delaware.