It is not absolutely necessary. It is possible to do business as a “sole proprietorship,” where you as a person just run the business. So what are some good reasons to incorporate your business?
To limit your liability
This is the number one reason why people incorporate. Running your own business as a sole proprietor leaves you with unlimited personal liability. That means, if your company loses a lawsuit and a judgment is entered against it, you personally have to pay for the judgment. Incorporating limits your liability to only three kinds of situations:
- The actor’s liability is unlimited
If you had a company that cleans swimming pools, you might have a lot of chemicals. Chemicals need to be disposed properly to avoid hurting the environment. If you poured pool chemicals into a pond and killed an endangered species of frog, you would be personally liable for that harm, and your liability would be unlimited.
- The manager is liable for the employee’s bad act
Suppose you were the manager of someone who poured chemicals into the pond in our example. Even if you did not know that the person was pouring out chemicals, wasn’t supposed to pour out chemicals, wasn’t supposed to pour them in the pond, that in the pond there were endangered frogs, etc., you would be liable because you knew or should have known that it was happening, and it would be reasonable to expect you to train your employees on how to properly dispose of chemicals.
- The owner or investor may be liable
Generally, owners and investors will not be personally liable for this chemical spill example. If the owner is also the manager, or the investor exerts control because of the portion of the entity it owns, it is possible for the owners or investors in a company to be held liable. For these situations it is a good idea to have liability insurance. There are other situations where the owner or investor may be liable. (See “When Courts will Pierce your Corporate Veil”)
For Taxes
If you operate as a sole proprietorship, all of your income is taxable. However, if you receive income through a company, you may be able to pay taxes only on your personal income, not the business income. There are two ways that companies are taxed:
- Subchapter “S,” for “S-Corps”
If your company has fewer than 100 shareholders, you can take advantage of the tax treatment referred as “pass-through” or “flow-through” taxation, so you only pay taxes on the income that the shareholders receive.
- Subchapter “C,” or “C-Corps”
If your company has more than 100 shareholders, you may have no choice but to be a “C-Corp,” which must pay taxes on both income to shareholders and profits in the corporation.
For Continuity
Sole proprietorships end when the proprietor quits, retires or dies. Partnerships end at dissolution, which can happen when a partier dies or the partners dissolve, after a length of time, or by agreement. While Corporations do not all last forever, (they can be created for a specific term or purpose) they can legally last forever. If you want your business to live beyond your lifetime, it may be wise to incorporate.
So you can Sell your Interest
Ownership interest in a corporate entity can be transferred freely in the form of shares or stocks. Difficulty only arises from supply and demand issues, like when nobody wants your stock, or if the company’s agreement includes a restriction on transference. (“Right of first refusal,” for example) Closely-held company shares are harder to appraise and sell, and harder still is a partnership interest because if you sell an interest in your partnership, the buyer only gets a share of the profits.
For Centralized Management
A corporation elects board of directors to manage the entire corporation, and those managers work together. For example, you may have a Chief Executive Officer, Chief Information Officer, Chief Marketing Officer, and Chief Financial Officer, working together to make the company run effectively. Annual meeting of shareholders allow proposals to be submitted and voted upon. It is the norm to have a board of directors.
There are many good reasons to incorporate your entity, and so it is widely considered a necessity when starting a new business. If you are starting your company alone, you may be able to put it off for some time, but once you begin to hire employees and grow, it is probably a good time to spend some time and effort on making your corporate entity.
What is a Sole Proprietorship?
