When starting a business, it's necessary to decide on its proposed legal structure, such as a sole proprietorship or a partnership. While the right option will likely depend on your size and your long-term goals, one of the most popular choices is to incorporate your business.
While there are different iterations of incorporation (such as the forming of a C corp or an S corp), it mainly refers to the legal process of forming your company as a corporate entity (designated by the use of terms such as 'Inc.' or 'LLC' after the company's name).
However, incorporation comes with its own distinct set of pros and cons. While the legalities involved in forming a corporation might differ depending on your location, the corporate structure is more or less the same. As a small business owner, it is up to you to take these benefits and drawbacks into account before arriving at a decision.
To help, we've compiled a breakdown of the main advantages and disadvantages of incorporation.
The Advantages of Incorporation
While you can incorporate your company from scratch, it is often a logical next step when a business shows signs of growth and expansion. Some key advantages of an incorporated business include:
Separation of business and individual assets
This is arguably the most significant benefit of incorporation. When a business assumes the identity of a separate legal entity, it is responsible for its own debts. This means that your personal assets are protected even if the company incurs liabilities or is sued; you cannot be held accountable for the performance of a corporation unless you have provided a personal guarantee.
Conversely, as a sole proprietor or a partner, your personal assets (such as property or vehicles that you own) can be seized if your business runs up significant debts. Also, a corporation is similar to an individual in that it can own property and conduct businesses.
Attractiveness to investors
The liability protection afforded by a corporation can boost investor confidence and help you raise funds by issuing more stock. Incorporation also lets your business issue more than one class of stock to help bring in capital. Having 'Inc.', 'LLC', or 'Corp' in your company name can prove fruitful to your business as it gives the impression of stability, thereby boosting shareholder – and customer – confidence significantly.
Guaranteed perpetual succession
A corporation can continue to exist for decades (or even centuries) after its founder (or founders) are no longer around. While the membership can keep changing, there is no impact on the existence of the organisation as an entity, which is not the case with other legal ownership structures.
Optimisation of taxes and income
Incorporation allows you to determine when and how you want to withdraw revenue from your organisation. As a result, you benefit from the flexibility of taking your income at a time when you will be liable for lower taxes. Instead of a salary, you can opt to receive income as a dividend, which can help to reduce your tax obligations. In some jurisdictions, an incorporated business might also qualify for a small business tax deduction.
Possibility of splitting income
This benefit can come in particularly handy if members of your family are also shareholders in the corporation. In that event, you might be able to channel income from a family member in a higher tax bracket to someone in a lower tax bracket while issuing dividends.
Safeguarding of the business name
When you incorporate your business, the name you choose for your company is usually reserved exclusively for your use in that particular jurisdiction (depending on your trademark situation, this might also apply further afield). Sole proprietorships do not enjoy this privilege; anyone can start another business with the same name as yours if you are not incorporated.
The Disadvantages of Incorporation
As with any aspect of running a business, incorporation also comes with its own set of disadvantages, too. These include:
Unfortunately, incorporation is not cheap; setting up your business in this way can be an expensive proposition. While the precise fee for incorporation will depend on the jurisdiction that your company is located in, you can expect to have to pay several sets of administrative and legal fees. You will also need to factor in the expenses of seeking external legal counsel to ensure the process runs smoothly, which in itself can be costly.
Aside from the increased financial costs of running a corporation, there is also the need to remain compliant with stringent legal and accounting requirements.
Records must be maintained of all management conferences, board meetings, and shareholder meetings, while all documents and financial statements must be regularly updated and correctly filed. Often, this means hiring accountants, attorneys, or other specialists, which again incurs additional expenditure. Failure to meet set regulatory standards at all times can have an adverse impact on the reputation of the organisation and even result in financial or legal penalties.
Risk of double taxation
Depending on the type of corporation your business is classified as, there is a possibility of double taxation occurring. This usually happens because the company has to file tax on its income, as well as any dividends paid to the shareholders.
Absence of personal tax credits
Single proprietorships are often eligible for different forms of tax credits, depending on their location. However, this does not apply to corporations who have to pay tax on every penny earned. Also, corporate losses cannot be deducted from your personal income, as is possible in a sole proprietorship or a partnership. In a corporation, you may be able to carry your losses forward or backwards in an attempted lowering of company income from those years.
Difficulty of dissolution
If, for any reason, if it is decided that the company should no longer exist, the dissolution process can prove drawn-out and time-consuming. It can cost a significant amount of money to see the whole process through, while final tax returns for the company will also have to be filed in accordance with the relevant law.
The form of business ownership you employ can change over time; small enterprises usually start as sole proprietorships, for instance, and then evolve into corporations once the business has sufficiently expanded. Therefore, familiarising yourself with the advantages and disadvantages of incorporation can stand you in good stead if and when the time comes.
Discussing the finer points of incorporation with a trusted accountant and lawyer will also give you gainful insights about whether the process is suitable – as well as specific information about the procedures followed in your location. Either way, the decision to incorporate is a major one that can have a significant impact on the future of your company, and you should always ensure that you understand the pros and cons fully before you commit to anything.
Is incorporation the best long-term business ownership structure? What do you think? Let us know your views and opinions in the comment section below.