Incorporating your Small Business
Why Should you Incorporate?
So you’ve set up your small business or sole proprietorship and you’re ready for business. The last things on your mind are taxes or potential lawsuits. But as they say “an ounce of prevention is worth a pound of cure.” Advantages of incorporating your small business are:
- Personal asset protection. The owner(s) have limited personal liability for corporate debts and obligations and generally are only subject to lose their investment in the business, but not their personal assets.For example: an independent cab driver who is sued for negligent driving would be personally liable if the damage exceeds what the insurance would cover. His personal bank account, investments, and other assets are at risk. Now if he had incorporated his business (e.g., L.L.C.), only his business assets would be at risk. His cab, business bank account, etc.
- Tax benefits. Losses are fully deductible for corporations, but for a sole proprietorship (i.e., an unincorporated business) his losses may be limited. There are also other tax benefits associated with various forms of corporate entities. Your attorney can determine which type of entity would be best for you.
- Business credibility. Adding the magic three letters, Inc. or L.L.C. after your business name adds instant legitimacy and credibility.
How do you Incorporate?
You must file the appropriate documents, such as the certificate of formation or bylaws, with the Texas Secretary of State.
In the certificate of formation, Texas requires the name of the corporation, initial directors (if applicable), purpose, duration, and the name and address of the corporate registered agent. You can choose who you designate as your registered agent, but it is beneficial to appoint your attorney as the agent. With a lawyer serving as the registered agent for your corporate entity, you will have the peace of mind that you will receive timely and prompt notice if your corporate entity is served with a summon and an attorney will be able to immediately to review and assess the lawsuit and provide you with legal advice on how to answer the summons.
LP, LLP, LLLP, LLC, Inc…what do I choose?
There are several ways of incorporating your small business.
A self-employed individual by default is a sole proprietorship. If you have not incorporated you are operating as a sole proprietor and have full personal liability for your business. Running a business without limited liability protection is like driving a car without insurance.
If you are a partnership and have not incorporated, you are by default a general partnership. Each partner in a general partnership is personally jointly and severally liable for their business liabilities. Owners report their share of income/losses on their own tax return and they are personally liable for their business. Just as a sole proprietorship, this not a recommended form since there is no liability protection for the owners.
A limited partnership consists of general and limited partners. General partners have personal liability for business debts but can raise funds without having outside investors manage their business. However, the general partners can limit their liabilities by forming a limited liability limited partnership. Limited partners are also protected from personal liability as long as they do not participate in management of the business. This form is commonly found in companies that invest in real estate because it is more attractive to lenders. Lenders do not like limited liability because it provides them less protection for their investment in your company.
Fringe benefits can be deducted as business expenses and owners can split profits among themselves and the corporation. This is generally the most expensive and burdensome to set up. It is rarely recommended for small businesses.
Limited Liability Partnership
This is similar to a limited partnership, except general partners are only liable for their own debts, and not the actions or debts of their fellow partners. This may be a good option for professional services firms where the members operate independently but under the same trade name.
Limited Liability Company
An L.L.C. is a hybrid of partnership and corporation that combines the best aspects of both entities. It offers the most flexibility in terms of operation and tax planning, as well as limited liability protection for all member(s). Also, unlike an L.L.P, an L.L.C. can have just one member. If it is a sole member L.L.C., you can choose to have it taxed as a separate entity or have the income and expenses “flow through” to your personal tax return. This is often the most recommended type of structure for self-employed individuals and small businesses.
The Best Structure for Your Business
Ultimately the best option for incorporating your small business will depend on a number of factors, such as the number of owners, type of business, how the owners wish to allocate business income/losses, long-term goals, whether you will raise capital through debt or equity, etc.
Beware of companies that will incorporate your business for a low fee using cookie-cutter templates. They will fill out the necessary paperwork, but they will not be able to advise you on the best entity formation for your needs. You need a qualified attorney that will review your situation to tailor the best choice for your business.