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"When should I incorporate my business?" is a common question asked by small business owners. Many businesses start out as sole proprietorships, but as they begin to experience success and grow, incorporation becomes a hot topic.
CT Tip: Technically, only a corporation is incorporated. An LLC is an unincorporated entity. The more accurate terminology is to say that an LLC is formed or organized. However, for simplicity, this article will use the term incorporate to include both corporations and LLCs.
But when is the ideal time to incorporate your business? Below are some key considerations to bear in mind.
It’s generally beneficial to form your company earlier rather than later. This is true regardless of the type of business and whether you opt to form a C corporation, S corporation, or LLC.
Benefits of incorporating early include the following:
As mentioned above, incorporation can protect your personal wealth from business liabilities. This is true for online businesses as well as brick-and-mortar businesses.
Corporations and LLCs have their own legal existence. The corporation or LLC can sign contracts, borrow and lend money, invest, and own property – all in its own name. The person who owns the corporation or LLC does not have to use his or her personal assets. Creditors can pursue the business assets but generally cannot reach your personal assets.
CT Tip: If you sign a contract as a sole proprietor and later incorporate, you are still individually liable on that contract. For that reason, it's generally better to incorporate or form your LLC before signing contracts, leases, franchise and other agreements, etc.
If a business has more than one founder, a clear understanding of ownership interests helps the business grow harmoniously and effectively. In some businesses, the intention is for all the owners to be equal. But in others, the intention is for some owners to have more financial and/or management rights than others. By incorporating early, and setting forth each owner’s financial and management rights in the governing documents, you can prevent any future misunderstandings and keep everyone on the same page regarding who owns what and who is owed what.
If your business owns intellectual property (copyrights, trademark, patents) or other property, incorporating could be an important step in ensuring the business owns that property rather than any individual founder.
Businesses that have or expect to have employees should incorporate before hiring them. Employers are generally liable for their employee’s actions and mistakes that are taken in the course of their employment. If you run your business as a sole proprietorship, you as an individual are liable and your personal assets are at risk. However, if you have incorporated, the corporation or LLC is the employer and takes on this liability risk.
Another good time to consider forming a corporation or LLC is when a sole proprietor wants to bring in a business partner as a co-owner. General partnerships (which are what are formed when two or more people go into business together without incorporating) have the same disadvantages as sole proprietorships – in particular, personal liability for the business’ debts. In addition to affording liability protection, corporations and LLCs make it easier to tell who owns how much, who has the decision making authority, etc.
One downside to forming a corporation or LLC is that it is more expensive than operating as a sole proprietorship. There are fees for incorporating and then annual (or in some states biannual) fees. Also, there are other compliance requirements – such as having to maintain certain records, appoint and maintain a registered agent, file annual reports, hold shareholder meetings, etc., that sole proprietorships do not have to deal with. In addition, if the owner decides to discontinue the business, as a sole proprietorship, the owner just has to stop doing business. Corporations and LLCs have to go through a formal dissolution and winding up process. So, if you are only in the planning stages of starting a business, you may wish to hold off incorporating until you have more concrete plans for important matters such as contract relationships, hiring employees, and taking on partners.
Once you know you’re starting a business, you’ll find that there are many incentives for incorporating earlier in the process. You will be able to sign contracts and other documents in the corporation’s or LLC’s name and take far greater advantage of the limited liability and other benefits incorporation can offer.
This article originally posted October 2016 and was updated November 2017.
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