FAQ: Should I Incorporate My Business?

The primary advantages of operating as a corporation are liability protection and potential tax savings. Like any important decision, choosing whether to incorporate involves weighing the pros and cons, and should only be done after careful research and consultation with a legal or tax professional.

Once incorporated, the business assets of the corporation are separated from the owner’s personal finances. As a result, the owner’s personal assets generally can be shielded from creditors of the business.

To maintain this legal separation (and avoid “piercing the corporate veil”), the corporation must observe certain formalities, including:

• Keeping corporate assets and personal assets separate (no commingling of funds)


• Holding shareholder and director meetings at least annually


• Maintaining a corporate record book including bylaws, minutes of shareholder and director meetings, and shareholder records


• Filing annual information statements with the Secretary of State


• Filing a separate tax return for the corporation

Many people are concerned about “double taxation” of income, but you should do your own research, and compare the features of the C-corporation and S-corporation. The double taxation results when a C-corporation has profit at the end of the year, and that profit is then distributed to the shareholders. That profit is taxed to the corporation, at the corporate tax rate, and then the dividends are taxable income to the shareholders on their personal tax returns. However, the corporate tax rate is typically much lower than the individual tax rate that a sole-proprietor will pay on a 1040 Schedule C, and a competent accountant can help the corporation minimize double-taxation (or eliminate it completely).

For example, a small C-corporation will likely have a shareholder who is also an employee. Paychecks to the shareholder/employee are, of course, tax deductible to the business. To the shareholder/employee, they are taxable income (as would be the case with a paycheck from any employer). A bonus could be paid to the shareholder/employee in order to lower the corporation’s taxable profit, eliminating the double-taxation. These calculations should be performed by your accountant or tax advisor, but shifting income from the corporation to the shareholder/employee (or vice versa, depending on which has the lower tax rate) can be a great way to lower your overall tax liability. In addition, there are certain advantages that are only available with a C-Corporation, such as full tax-deductibility of medical benefits for a shareholder/employee.

The S-Corporation avoids the double-taxation by offering a tax structure similar to the Limited Liability Company (LLC, which is not an option for businesses that are required to hold a license, certification or registration). A corporation with 100 or fewer shareholders can elect to be treated as an S-Corporation. If the corporation is profitable, the shareholder/employee must draw a reasonable salary (and pay employment tax on it), but then all remaining corporate profits flow through to the shareholder’s personal tax return (thereby avoiding the FICA tax on the portion of profits that is taken as a dividend).

Before deciding to incorporate, you should seek legal and tax advice on what type of ownership best suits your business. An experienced attorney and tax advisor can help you decide which form of ownership is best for your business. For the do-it-yourselfers, we highly recommend “Own Your Own Corporation” by Garrett Sutton, Esq. (part of the Rich Dad series).

Partnerships: An Overview

The General Partnership

A partnership is a relationship existing between two or more persons who agree to share profits and losses. A partnership is usually based on a partnership agreement of some type. No formal, written document is required in order to create a partnership. If a formal agreement is not signed, the partnership will be subject to the applicable state laws governing partnerships.

Disadvantages

Like the sole proprietorship, owners of a partnership have no asset protection. Each partner’s personal assets are at risk. However, with a partnership, the owners face twice the liability exposure of a sole proprietorship. Any partner may obligate the partnership, and each individual partner is liable for all of the debts of the partnership, regardless of which partner may have been responsible for their accumulation.

In addition to the risk of personal financial liability, general partners also face potential personal legal liability for the negligence of another partner. Furthermore, each partner may also be liable for the negligence of an employee of the partnership if such negligence takes place during the usual course of business of the partnership.

Continuity is also an issue for the partnership. A partnership terminates when one partner dies, leaves, or goes bankrupt. In addition, it often very difficult to sell an interest in a partnership. Most sophisticated buyers do not want the risk associated with a general partnership.

Finally, certain benefits of corporate organization are not available to a partnership. Since a partnership cannot obtain financing through public stock offerings, large infusions of capital are more difficult for a partnership to raise than for a corporation. In addition, many of the fringe benefit programs that are available to corporations (such as certain pension and profit-sharing arrangements) are not available to partnerships.

Advantages

For a business in which two or more people desire to share in the work and in the profits, a partnership is often the structure chosen. It is, potentially, a much simpler form of business organization than the corporate form. There are fewer start-up costs and regulation of partnerships is limited. However, this simplicity can be deceiving. A sole proprietor knows that his or her actions will determine how the business will prosper, and that he or she is, ultimately, personally responsible for the success or failure of the company. In a partnership, however, the duties, obligations, and commitments of each partner are often ill-defined. This lack of definition of the status of each partner can lead to serious difficulties and disagreements. In order to clarify the rights and responsibilities of each partner and to be certain of the tax status of the partnership, it is good business procedure to have a written partnership agreement.

The Limited Partnership

A limited partnership is similar to a general partnership, except that it has two types of partners: general partners and limited partners.

General partners have broad powers to obligate the partnership (as they do with a general partnership). General partners are also personally liable for the debts and claims against the partnership. If there is more than one general partner, each of them is liable for the acts and omissions of the remaining general partners.

Limited partners are “limited” to their contribution of capital to the business, and may not become actively involved in running the company.

As with a general partnership, limited partnerships are flow-through tax entities.

Disadvantages

General partners are personally liable for all partnership debts. However, a corporation or an LLC may be formed to serve as the general partner, thereby limiting the limiting the potential for personal liability.

Because limited partners are prohibited from participating in the management activities of the enterprise, the general partners maintain complete control of the partnership’s business affairs. Limited partners have no control of their investment.

Advantages

Limited partners are not liable for the partnership’s debts beyond the value of their capital contribution into the business. Creditors of a limited partnership can only reach the partnership assets and those of the general partner (which is further limited by utilizing a corporation or LLC as a general partner).

Creditors of the individual partners can only reach the partner’s ownership interest in the partnership, but not the partnership assets themselves.

With proper estate planning, family assets can be transferred from one generation to the next at discounted rates. By using a family limited partnership, gifting can be accelerated with an IRS-approved discount. If you are considering this option, you should consult with an attorney.

Limited partnerships afford a great deal of flexibility to the partners. A written partnership agreement can be tailored to the business, family and estate planning needs of any situation.