Incorporating Your Business

If you've been in business for a while as a sole proprietor, you may be wondering whether it would be a good idea to incorporate. We can help you make that decision with advice on: why a business owner would want to incorporate, how a corporation is structured, and how corporations are taxed.

Reasons for incorporating

Picture this: You started a small landscaping business a few years ago as a sole proprietorship with three employees. Demand was so great for your services that you kept hiring more people and taking on debt to purchase more equipment, and the number of customers has soared. But lately you've started to wonder: What happens if business slows and you can't pay back all the debt? What if a disgruntled employee or unhappy customer sues you? As a sole proprietor you're personally liable for any bad debts and legal judgments against your business, meaning that your home and other personal assets are at risk.

When you incorporate your business, you're creating a completely separate legal entity, one that shoulders the liability burden you had been carrying yourself (or if you are a partnership, the burden you and the other partners were carrying).

Forming a corporation also allows you to:

- Reward and retain key staff by giving workers a piece of the business
- Have more options for raising funds. Instead of going into more debt, you can
attract equity investor.
- Shift tax liability away from you to the corporate entity

But you'll have to weigh some disadvantages as well:

- It takes more time and money to incorporate than to form other types of
businesses.
- Corporations are subject to more regulation at both the federal and state level.
- The management structure of a corporation is more rigid, giving you, as the
owner, less flexibility to run things as you see fit.

Corporate structure

Each corporation has a three-tiered structure, which consists of:

1) Shareholders: As company owners, they are the linchpins of the corporation. They have the power to select and remove directors, amend bylaws, approve the sale of assets and dissolve the corporation. You don't necessarily have to have a lot of shareholders. In fact, most states permit one person to hold 100% of the corporation's stock.

2) Directors: They act on behalf of the stockholders, managing the company, making major decisions about the firm's direction and electing company officers. Most states allow corporations to have a single director, but some require a minimum of three.

3) Officers: In most states, corporations must have at least a president, secretary and treasurer to handle day-to-day running of the business, but many states also allow one person to hold all three positions.

Steps to becoming a corporation

To get your corporation started, you'll need to draw up Articles of Incorporation in the state where your business is headquartered. The articles declare basic facts about the company, including its name, purpose and the number of shares authorized. You file this document with the appropriate state office (usually the Secretary of State or Department of Commerce) and pay a filing fee, which can run several hundred dollars. You may want to hire an attorney to handle the process. The state will process your filing and send you a Certificate of Incorporation.

With your Certificate in hand, you can take the next steps, including appointing directors and holding your first directors' meeting. You'll need to draw up bylaws, which detail the rights of the shareholders, directors and officers. You also must issue stock. It doesn't have to be widely-held, but must be distributed to everyone who is an owner of the corporation.

Tax issues for corporations

Once you have incorporated, you'll notice a big difference in how your company is treated for tax purposes. You'll no longer file Schedule C and report your net profit or loss on your 1040. Instead, the corporation files a business tax return, Form 1120, and pays tax on its corporate profits. If you're a small corporation, you may be eligible to file the short form, 1120-A. To do so, you must meet a long list of eligibility requirements, but the key point is that your company's gross receipts, total income and assets each must be less than $500,000.

Many owners of new, small corporations may get a pleasant surprise at tax time. That's because sole proprietors can't deduct any salaries they pay themselves, but after incorporating they become employees, and their compensation can be written off by the corporate entity. Once those and other deductions are taken, there may be little corporate profit left to tax. But shareholders do have to pay tax as individuals on any dividends they receive from the corporation

A valuable tax break

Even better news: Self-employed business owners no longer have to pay the self-employment tax after they incorporate. As a sole proprietor, you pay your full Social Security and Medicare tax liability, which in 2008 is 15.3% on the first $102,000 of your net earnings from self-employment. For earnings above that, you pay Medicare tax of 2.9%. (For 2009, the full tax applies to the first $106,800 of earnings.) As an employee of your corporation, the firm withholds half of your employment tax from your paycheck and pays the other half for you.

There are a few key terms you should know when incorporating your business:

Articles of Incorporation: A document that is filed with the proper state authorities and explains the purpose of the corporation, name, primary place of business, names of directors, and the amounts and types of stock it can issue.

Articles of Organization: LLCs must file these documents; these articles are very similar to the Articles of Incorporation.

Contract: An agreement between two or more parties that creates a duty to do or not do something and a right to performance of the other's duty or a remedy for the breach of the other's duty.

Copyright: The legal right granted to an author, composer, playwright, publisher, or distributor to exclusive publication, production, sale, or distribution of their literary, musical, dramatic, or artistic work.

C corporation: A C-corporation, or C-corp., is a corporation whose shares are held by the shareholders and may be publicly traded.

Directors: Individuals who are elected by shareholders who make major policy decisions.

Foreign corporation: A corporation that conducts business in an area where it was not formed.

General partnership: A partnership where each partner is liable for all debts and obligations, regardless of the individual's capital contribution.

Incorporation: A separate legal entity to conduct business. Their rules assist in the interests of the shareholders that invest their capital and the employees that contribute their time and labor.

Intellectual Property: A creation of the intellect that has commercial value, which includes copyrighted property such as literary or artistic works and ideational property, such as patents, appellations of origin, business methods and industrial processes.

Joint Venture: A business agreement or partnership between two or more individuals that is limited to a single enterprise that involves the sharing of resources, profits, losses and control.

Limited Liability Partnership: Liability of all partners is limited. In most cases, the partners are not responsible for obligations, debts, or liabilities of the partnership resulting from actions of the other partner, agent, or employee of the partnership.

Limited Partnership: A partnership where the business is managed by one or more general partners. Capital is provided by limited partners who do not participate in management, but share profits and their liability is limited to their respective capital contributions.

Non-Disclosure agreement: A contract whereby one promises to treat information confidentially and not give out information without proper authorization.

Non-profit corporation: A corporation that benefits members of an organization for a public purpose. The business cannot be designed for profit-making purposes and the profits must be used to benefit the organization.

Partnership: Owned by two or more people and are personally liable for all business debts and obligations.

S corporation: A corporation with a limited number of shareholders that is treated as a partnership for tax purposes.

Sole proprietorship: A business owned and operated by one person. He or she is personally liable for all business debts and obligations. The owner and the business are one entity and profits are reported on the owner's personal tax return.

Trademark: A name, symbol, or other device identifying a product, officially registered and legally restricted to the use of the owner or manufacturer.

From a legal point of view, there are three common types of businesses: sole proprietorship, partnership and corporation. Each has different and important implications for liability, taxation and succession. A lawyer or accountant can advise you on which is suited to your needs, and undertake the necessary formalities.

Advantages and Disadvantages of Proprietorship

This is the simplest way to set up a business. A sole proprietor is fully responsible for all debts and obligations related to his or her business. A creditor with a claim against a sole proprietor would normally have a right against all of his or her assets, whether business or personal. This is known as unlimited liability.

In a proprietorship, one person performs all the functions required for the successful operation of the business. The proprietor secures the capital, establishes and operates the business, assumes all risks, accepts all profits and losses, and pays all taxes. The proprietor is said to be self-employed.

Advantages

- Low start-up costs
- Greatest freedom from regulation
- Owner in direct control of decision making
- Minimal working capital required
- Tax advantages to owner
- All profits to owner

Disadvantages

- Unlimited liability
- Lack of continuity in business organization in absence of owner
- Difficulty in raising capital

Advantages and Disadvantages of Partnership

A partnership is an agreement in which two or more persons combine their resources in a business with a view to making a profit. In order to establish the terms of the partnership and to protect partners in the event of a disagreement or dissolution of a partnership, a partnership agreement should be drawn up. Standard form partnership agreements can also be purchased for about $5.00 at stationary stores. Partners share in the profits according to the terms of the agreement.

In a General Partnership, two or more owners share the management of a business, and each is personally liable for all the debts and obligations of the business. This means that each partner is responsible for, and must assume the consequences of, the actions of the other partner(s).

A second type of partnership is a Limited Partnership which involves limited partners who combine only capital. They are not involved in managing the business and cannot be liable for more than the amount of capital they have contributed. This is known as limited liability.

A limited partnership also involves general partners, who are involved in management. They are fully liable for the debts and obligations of the business, but may be entitled to a greater share of the profits.

Advantages:

- Ease of formation
- Low start-up costs
- Additional sources of investment capital
- Possible tax advantages
- Limited regulation
- Broader management base

Disadvantages:

- Unlimited liability
- Divided authority
- Difficulty in raising additional capital
- Hard to find suitable partners
- Possible development of conflict between partners
- Partners can legally bind each other without prior approval
- Lack of continuity

Advantages and Disadvantages of Incorporating

A corporation, also known as a Limited Company, is a legal entity which is separate and distinct from its members (shareholders). Each shareholder has limited liability. A creditor with a claim against the assets of the company would normally have no rights against its shareholders, although in certain circumstances shareholders may be held liable. It is recommended that legal advice be sought. This type of business can be incorporated at either the federal or provincial level.

Ownership interests in a corporation are usually easily changed. Shares may be transferred without affecting the corporations existence or continued operation.

The following characteristics distinguish it from a partnership or proprietorship:

Limited liability - normally no member can be held personally liable for the debts, obligations or acts of the corporation beyond the amount of share capital the members has subscribed; and

Perpetual succession - because the corporation is a separate legal entity, its existence does not depend on the continued membership of any of its members.

Advantages

- Limited liability
- Possible tax advantage (if you qualify for a small business tax rate)
- Specialized management
- Ownership is transferable
- Continuous existence
- Separate legal entity
- Easier to raise capital

Disadvantages

- Closely regulated
- Most expensive form to organize
- Charter restrictions
- Extensive record keeping necessary
- Double taxation of dividends
- Shareholders may be held legally responsible in certain circumstances
- Personal guarantees undermine limited liability advantage