Among all the decisions and actions a small business may need to take, one of the more important is deciding whether to incorporate or form an LLC.
January is the most logical start date for a new LLC or corporation since it eases the paperwork burden. Your clients can start fresh in the new year with their new legal structure and don’t have to worry about reporting taxes as two different entities for the tax year.
At this time of year, sole proprietors and general partnerships may be wondering if it’s time to create a formal business structure like a corporation or LLC. To that end, here are five of the main reasons why a small business would choose to incorporate or form an LLC:
1. There are liability concerns
You’re probably already aware that when your client is operating his or her business as a sole proprietor or general partnership, there’s no separation between them and the business. The individual owners are responsible for signing contracts and taking out loans. They are also personally responsible should a customer, vendor or someone else sue the business, or a creditor seeks action. This means your client’s personal assets are at risk for things that happen in the business.
A corporation and LLC put a wall or “corporate veil” between the owner and the business. As long as the company complies with all the necessary corporate formalities, then creditors and court judgments generally cannot reach an owner’s personal assets to satisfy the company’s liabilities.
If your client is just starting out, they might be thinking, “Hey, I don’t have that many personal assets to worry about protecting.” It’s important to remind them that creditor judgments can actually last up to 22 years, so they’re not only putting their current assets at risk, but any assets they might accumulate over the next two decades as well.
2. They want to start building business credit
Sole proprietors and general partners need to sign contracts in their own name. Your clients will need to rely on their own personal credit and assets to take out a loan or ask for a line of credit. When your client forms an LLC or corporation, the business begins building up its own credit profile that’s separate from the business owners.
In addition, if your client is looking for a third party investor, there needs to be some kind of entity set up to accept the investment. Venture capitalists and other investors often prefer to work with corporations, since they allow for different classes of stock.
3. They want to issue stock options
Maybe your client wants to compensate or entice employees, vendors or contractors by granting stock options or providing the opportunity to purchase equity in the business at a low price. As a sole proprietor or partnership, it could be possible to put together a pre-incorporation agreement that stipulates that someone will get stock upon incorporation. But, if your client is really serious about the stock option/equity route, it’s a lot simpler to incorporate the company first, and then make the offers.
4. There’s a risk of misunderstandings among founders/partners
Whenever there’s more than one founder involved in a business, there’s always a chance of an argument or misunderstanding about how equity should be split. This is true even if owners are relatives, partners or close friends. Incorporating a company and issuing stock eliminates the chance of any misunderstanding. And, if your client chooses to form an LLC instead (and not issue stock), they can still create formal paperwork in the operating agreement that spells out exactly how ownership is split. In short, these structures add a layer of formality that can be very necessary when dealing with multiple parties.
5. There are potential tax advantages associated with a corporation or LLC
You know best if the corporation or LLC structure will confer some tax or financial benefits to your client. Are corporate tax rates lower than individual tax rates in their circumstances? Would electing S Corporation tax status (as a corporation or LLC) help your client lower their self-employment tax burden?
If there are any tax advantages to incorporating or your client is concerned about liability, then it’s best to incorporate or form an LLC as quickly as possible. January is a great start date, but keep in mind that January is also the busiest time of year for processing incorporation applications at many Secretary of State offices. In some cases, it can take close to 60 days to bring a corporation or LLC into existence after filing the documents.
One option is to use a “delayed filing’ option with a document filing service. You can help your client complete their LLC/corporation paperwork now, but then delay the incorporation date until next year. This means the application will be fast tracked to the front of the line when the secretary of state office opens in the beginning of the year.
When it comes to incorporating or forming an LLC, the most important thing is to get the ball rolling. And the end of one year/beginning of the next year is a great time to open that conversation.