There comes a time when every small business owner wonders whether he or she has chosen the right business structure. It’s best to do this kind of ruminating right at the outset, when you have the freedom and flexibility to make decisions. Once the business is up and running, it’s very difficult and disruptive to change from a sole proprietorship or partnership to a corporation.
The key question is whether you need to incorporate, and what are the pros and cons of incorporation for small businesses.
The cost of registering and operating a small business as a sole proprietorship or partnership is relatively low as compared to incorporation. The costs differ by state, so you should check with the proper regulatory authority in your state.
For the purposes of this article, let’s consider the costs in Delaware, which is a popular place for business incorporation, regardless of the state in which you plan to do business.
The basic incorporation filing fee is $89. You may need a registered agent and there are costs associated with things such as the articles of incorporation, bylaws, director resolutions, express mailing fee, certificate of incorporation, and other customized needs that your business may have. From the second year onwards, you’ll also be paying a franchise tax.
The filing fee for an LLC (limited liability company) is $90, and you’ll be paying an annual $200 LLC tax. Sole proprietorships do not need to register with the state, but if you use a trade name different from your own name, you will have to spend $25 to register the trade name in the superior court.
Reporting and Compliance: Sole proprietorships and partnerships are pretty much left alone by the state, as long as you are a registered business with all the requisite licenses, and you pay federal income and payroll taxes (if any).
Corporation, on the other hand, must maintain bylaws, hold meetings of the board of directors and record the minutes.
This is where it gets interesting, because corporations face double taxation in the form of corporate tax and then personal income tax on your earnings which may be in the form of wages, dividends and bonuses.
Sole proprietorships and LLCs, on the other hand, benefit from pass-thru taxation. This means the profit or loss from the business is passed on straight to the owner without being taxed. The owners must then show the profit as income in their personal tax returns.
On the face of it, this may seem like a slam-dunk for sole proprietorships, but the difference between the low corporate tax rate and higher personal income tax rate often makes it more even. You may actually even end up paying less tax overall as a corporation.
There’s not much to discuss about here. Sole proprietors bear full liability for their business, while LLCs and corporations offer the protection of limited liability. Your personal assets are safe, and your liability is limited to the stake you have in the corporation.
Above all these issues, there remains the fact that every small business wants to become a big business, so to speak. This needs investors, which in turn calls for a professional approach – in other words – an incorporated company.
No VC fund is going to hear your proposal or act on it if you are registered as the sole proprietor. They need a business structure that won’t fall apart if you decide you don’t want to be a part of it anymore.
Richard A. Rosa, CPA serves clients in the Greater New York area. Richard has recently taken up blogging, and offers weekly updates about tax law, accounting news and analysis.
Image courtesy Carl Malamud