Many small business startups begin as sole proprietorships or partnerships. The low cost and convenience of these legal structures helps you get started quickly. However, it is important to review how a business is structured as your company grows.
Your staffing, taxes and liability often change over time. As your business expands, incorporation may be advised.
So, what are some indicators that it’s time to incorporate?
Here are some telltale signs and strategies:
Most startups have basic cash flow models. Revenue is realized and expenses are paid mostly on demand. However, your cash flow often changes over time.
You may now invoice customers and have accounts receivable (A/R). A line of credit or credit card helps meet recurring expenses during these gaps in cash flow. To meet customer demand, you could need new equipment financing to improve productivity.
General partners and sole proprietors often finance their ventures with personal credit cards or even home equity. If business obligations can’t be met, creditors can more easily pursue individual assets.
Since a corporation is a distinct entity, incorporating better protects your estate against the inability to repay a business loan.
Your Taxes and Business Structure
Corporations do face higher taxes than sole proprietorships. Rather than your personal tax bracket, corporations are first taxed at a corporate rate.
Do you need to draw money from the net income? Personal tax rates are then applied to this distribution, creating a double tax.
Forming an S Corporation or Limited Liability Company (LLC) helps avoid this double taxation. S Corps and LLCs are pass through entities, meaning income paid goes directly to shareholders and is taxed at their personal rates.
You are Hiring Employees
Adding employees signifies growth. You are investing in productivity to serve more customers. Despite these positives, you should consider the liability that accompanies hiring a staff.
Employees that commit unlawful acts can expose you to personal liability. This risk is more complicated when you do not have the time or resources to effectively screen employees.
Small business owners can minimize liability with periodic review of their legal structures. As a corporation, you have limited liability to the harmful or unlawful actions of staff. Incorporating may be especially valuable if your employees work alone or with minimal supervision.
Professional accounting may be needed when business cash flow becomes more complex. Some sole proprietors may not have the time or savvy to prepare their own taxes when depreciation expense and interest expense become factors.
Since sole proprietorships (SPs) mix personal and business taxes, there is more potential to misreport income or deductions. As a result, sole proprietors (SPs) are at greater risk of IRS audits.
Even though tax audits are supposed to be random, incorporating may remove a prime ‘warning signal’ for the IRS. A CPA or tax professional also helps advise on business strategies that are not apparent.
Corporations survive if an owner is incapacitated or passes away. Conversely, SPs cease to exist once the owner steps aside. A partnership is also dissolved if any one owner leaves.
Incorporating allows a business to continue even if you choose to no longer be involved. This also facilitates estate planning, as you may choose to pass the business on to children or others.
Reviewing Your Legal Structure is a Best Practice
Liability and taxes are common considerations for different small businesses. Periodic review of your business gives insight into which legal structure is most beneficial.
Please consult a CPA or legal professional as needed.