Reasons to Incorporate Your Small Business

One of the most common concerns of small business and owners is when they should consider forming a corporate entity of some sort to use in running their small business. This is an issue that is unique to every small business owner, but becomes particularly important when the small business starts to have some success in producing revenue.  It is less important when a small business is in its very infancy and is not producing any revenue.  However, when it comes time to obtain financing, it is particularly important for several reason.  Some are related to liability issues for the small while others are related to taxation.   Finally, lenders will often require that your small business be incorporated before they are willing to even consider extending financing to you.

Limiting Personal Liability for Corporate Actions and Debts of Your Small Business

The first issue when considering whether to incorporate your small business are the liability protections offered by incorporating a small business.  As long as the small business owner respects the corporate formalities (i.e. not using corporate funds for personal expenditures like improvements to the homeowner’s house, using a corporate credit card to pay for his or her groceries, etc.), then the small business owner cannot be sued for contracts signed by the corporate entity or defaulting on financial obligations of the corporate entity.  This separation is important from a legal perspective because it entitles a small business owner to take risks by starting a business and obtaining financing for his or her small business but not worrying that his or her house, cars or retirement savings are at risk.  Therefore, one of the most important features of an incorporated business entity is the limitation on the liability for debts and obligations of the small business if the small business is incorporated.

Incorporating a Small Business Is More Tax-Efficient than Operating the Small Business as a Sole Proprietorship

Incorporating a small business is often much more tax efficient for the small business owner than simply running the small business as a sole proprietorship.   (For purposes of taxation purposes, you are considered a sole proprietor if you are operating a small business and you are not doing so using a corporate entity of some kind.)  However, this is incredibly tax-inefficient if your small business is producing revenue because there a number of tax deductions that you can utilize if you incorporate your business and file your taxes separately as a corporation.  When a small business owner operates his or her business as a sole proprietorship, the small business business owner pays self-employment taxes on the revenue that comes into the small business.  This means that the small business owner pays both the employer and employee’s side of FICA (Social Security and Medicare) taxes.  However, if the small business owner were to operate as an S corporation and pay him or herself a salary, he would then only be responsible for personally paying the employee’s side of the FICA taxes on whatever salary the small business pays the owner.  In addition, there are a number of expenses that are tax deductible by the small business if it is incorporated that cannot be deducted by the small business owner on his or her personal income tax return.

Lenders May Refuse to Lend to You if Your Small Business Is Not Incorporated

            If you are seeking financing for your small business and your small business is not incorporated, then lenders may refuse to extend financing to your small business to expand your business, help you with day to day expenses, open a new location, or whatever reason you are seeking financing for.

The Process of Incorporation is Relatively Simple and Does Not Require Using a Lawyer

The process of incorporating a small business is cheap and fairly simple in most states and does not require the use of a lawyer or a service like LegalZoom.  Instead, small business owners can typically easily incorporate the business themselves.  For example, in California, the California Secretary of State maintains a website which provides sample forms for incorporating a small business in that state.  A small business owner can simply fill out the form corresponding to whatever type of corporate entity he or she would like to establish and then fill out the appropriate paperwork and file it with the California Secretary of State.  The cost of incorporating a small business is also cheap in California, as it only costs $100 to form an S corporation under California law.

Takeaways

  • Incorporating your small business is a must-do when your business starts to produce revenue or you are thinking of seeking financing for your small business. Doing so is often required by many lenders in order to obtain financing for your small business, as lenders often will not extend financing to small businesses that are not incorporated.
  • Incorporating your small business will limit your personal liability for contracts you may enter into on behalf of the small business or debts of the corporation. It also will enable you to save on taxes as compared with operating your small business as a sole proprietorship.

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