Pros and Cons of Incorporating

By Mark D. Hazlett

Deciding which business structure is best suited to your needs can be a difficult task. In this article, we hope to provide some food for thought if you are considering incorporation.

Often, a small business will start out as a sole proprietorship or a partnership. A sole proprietorship is essentially an extension of the owner.[1] A general partnership is similar except with two or more people. Each partner would contribute something to the business and receive a share of the profits and losses in exchange. All partners are personally liable for any partnership debts. In contrast to a sole proprietorship or general partnership, a corporation is a separate legal entity from its shareholders.

Incorporation offers a number of advantages and disadvantages. Some of the main considerations are outlined below.

Advantages:

1. Tax Benefits and Potential Deferral of Income

There are three ways that incorporation can lead to tax benefits. First, incorporating your business allows for increased flexibility when filing taxes. Instead of having to claim all of the business’ profits as income, incorporation allows for funds to be left in the business, thus being subject to the lower corporate tax rate instead of a higher personal one.[2] Next, incorporation allows business owners to leave part of their income in the business, to be taken in a later year, when they (hopefully) are in a lower tax bracket. Finally, corporations allow for increased flexibility regarding how and when to receive income. For instance, a shareholder could elect to receive part of its income through dividends, which are subject to a lower tax rate than regular income.

2. Limited Liability

Since a corporation is a separate legal entity from the shareholders, it offers a layer of protection, as shareholders cannot generally be held personally liable for claims made against the corporation. Any legal action would be brought against the corporation and its assets, as opposed to each shareholder’s personal assets.[3] This does not mean, however, that a shareholder who directly runs a corporation cannot be held liable for anything, particularly if they act as an officer or director of the corporation.

3. Increased Perception of Credibility

Using a corporation rather than a sole proprietorship also may provide the veneer of a higher level of professionalism or sophistication to a business. As a practical result, there are often more grants and financing available to incorporated businesses.[4] Many banks and investors will prefer that a business be incorporated to qualify for certain funding.[5]

4. Corporations Offer Continuity

Corporations can be useful tools because of their unlimited lifespan. This increases the likelihood of success over a long period of time, as changes within shareholders, such as if one leaves or dies, will often be less detrimental. Since all assets belong to the corporation rather than the shareholders themselves, changes in corporate ownership carries all of the corporation’s assets with it – meaning that changes in the shareholding of corporations will often be more straightforward to deal with than the assets of a sole proprietorship or partnership should a partner be added or removed.

Disadvantages:

1. Additional Costs

Due to the use of a more complex legal entity, there are a number of costs associated with incorporation including the initial filing costs, as well as increased ongoing legal and accounting expenses.

2. Additional Paperwork

The rules and regulations associated with incorporation will also increase the administrative burden on its directors, as there will be additional tasks that will require completion. For instance, the corporation will require the filing of a corporate tax return and the annual return. Further, there are a number of records that must be maintained in the corporation’s minute book including the articles of incorporation, bylaws, information about meetings, and registers of directors, officers, and shareholders/members.

3. No Access to Personal Tax Credits for Losses

If your business is a sole proprietorship or a partnership, shareholders may be eligible to personally claim any losses that their business incurs against their personal income. Once incorporated, any losses must remain with the business. However, those losses can potentially be carried forward to deduct against future profits of the corporation.

For further inquiries on incorporating your business, please reach out to Mark Hazlett at mhazlett@sorbaralaw.com.