Why you Should Consider Changing your Sole Proprietorship to a Corporation or LLC

23
April 2021

You would never risk going on a road trip without car insurance or expect your favorite quarterback to make it to the end of the field without wearing a helmet. So why would you ever think of leaving your small business unprotected? Moral of the story here, you need a solid legal structure to back you and your small business on your way to success.

And no, we’re not talking about strengthening your sole proprietorship, we’re talking about creating a Limited Liability Company or Corporation. These legal structures can help your business grow while limiting your personal risks as a business owner.

Here’s some useful information to clear your doubts, weight advantages and help you pick the right entity for your business. Before you are halfway through this article, you’ll realize sole proprietorship doesn’t stand a chance.

5 reasons to incorporate your small business:

1. To protect your assets

Perhaps the biggest and most important difference between an LLC and a sole proprietorship is that when you form an LLC, you are creating a legal business entity that remains separate from your personal identity as the business owner.

If you’re concerned about your exposure to a lawsuit or debts, running your business as an LLC or Corporation is a good idea. With sole proprietorship, small business owners risk putting all their eggs in one basket- and with eggs we are talking about assets. With an S-corp or LLC status, your personal assets are shielded from lawsuits and bankruptcies. 

A corporation carries the least amount of personal liability since the law holds that it is its own entity. This means that creditors and customers can sue the corporation, but they cannot gain access to any personal assets from shareholders. An LLC offers the same protection, but with the tax benefits of a sole proprietorship.

2. To raise the credibility of your business

Setting up a legal business entity for your business makes your business “official.” Instead of just doing business as an individual person and having your customers pay you directly, setting up an LLC gives you the ability to do business as a separate legal entity, in this case, as a business.

This in turns sends out a solid message that you are serious about what you do. When you incorporate, you gain a sense of higher worth in the eyes of new customers. In fact, more consumers and vendors prefer to do business with a corporation or LLC rather than an individual. Having “Inc” or “LLC” after your company name can lend an air of legitimacy to your small business.

Also, think of the benefits behind credibility and legitimacy. It's a way to protect your small business identity and everything that goes along with it: it’s name, brand recognition and trademark.

3. Longevity and Perpetual Existence

Grow your corporation for now, for tomorrow… and forever! It sounds intimidating, you can’t live forever but your corporation can! Even if an owner dies or sells interest, the corporation still exists.

And no, we don’t mean to creep you out, but Perpetual Existence does exist. And it gives you the ability to create a long-term growth plan within your business and most importantly, it allows your business to remain operational without the need to reestablish itself multiple times.

If you’re a sole proprietor and close your business or pass away, the company goes away too. If your business is a corporation or LLC, it can continue operating in your absence. If you plan to pass your business along to your children or to a partner, an LLC or S-corp may be the way to go. It is important to know, of course, that your business can still be sold or that you may close it at some point.

4. To improve your chances of securing working capital for your business.  

Lack of access to business financing, might potentially limit your growth plans. Corporations have an easier time obtaining outside funding than sole proprietorships. By incorporating, you are making it easier for your business to raise capital, either by borrowing money or applying for a loan. In fact, lenders or even alternative funding programs often require businesses to incorporate before allowing them to receive funds. Funders like to see that you maintain separate business and personal finances.

Sole proprietors can only obtain funds through their personal accounts, using their personal credit or taking on partners, while corporations can sell shares of stock and secure additional funding for growth.  Also, when you incorporate, it means you can open up a bank account and start building a line of credit, which for a small business owner is a necessity.

5. Tax benefits and money savings

Another crucial benefit behind incorporating your business are the many tax deductions that that will be available for your business and that are not available to individuals. Everything from tax deductions on health insurance and life insurance, to savings on self-employment taxes.

You may be able to deduct business losses, investments and even travel expenses related to your business. And gain the ability to claim many daily expenses required to operate your business and deduct Social Security taxes that you’re paying into the system. Also, your local and state taxing authorities may offer incentives to you more readily if you are a corporation. But remember, before you take the leap, keep in mind that tax laws are complex, and it’s best to consult a CPA before claiming any deductions.

So… which business entity is better suited for you?

To pick the right legal structure for your business, first look at your company’s goals, business structure and consider local, state and federal laws. As your business evolves, you can modify your legal structure to meet your business's new needs. Here are the most notable features about three most common types of business entities.

C-corporation 

A C-corporation (a C-corp) is an independent legal entity that exists separately from the company’s owners. This type of business entity is owned by shareholders and taxed as a separate entity. 

The advantages? C-corps allow an unlimited number of investors (shareholders) and thus, extend unlimited growth potential through the sale of stocks. Additionally, they offer significant tax deduction benefits- especially for employers who can claim a 100% deduction of employee health insurance costs as well as other deduction benefits such as group term life insurance, or business-provided vehicles. Corporate tax rates are also typically lower than the individual tax rates of sole proprietors or LLC owners. 

The downside: They receive double taxation; revenue is taxed at the company level and as shareholder dividends. Also, corporations are subject to pay fees to the state in which they operate.

S-corporation (S Subchapter)

An S-corp is a common structure among small businesses where individual owners pay taxes on their company’s earnings without paying separate business taxes on the entity’s net income.  

This type of entity is taxed as a corporate level and is not subject to double taxation as a C-corp is. Using this structure could help alleviate the steep income and self-employment taxes that sole proprietors pay.

The advantages? In order for your business to qualify as an S- Corp it must meet specific Internal Revenue Code requirements. Your business must first be established as a C-crop and file for subchapter S- Corp status. These are some of the requirements it should meet: have fewer than 100 shareholders who are all individuals, not corporations; have only one class of stock; and be owned by U.S. citizens or resident aliens. Fortunately, these are all requirements that many small business owners can easily qualify for.

The downside: But do keep in mind, that if you opt for an S-Corp, you should count on a solid accountant, as one mistake in filing can send your company back to C-Corp status, leaving it open to be taxed twice.

An LLC, a Limited Liability Company

A limited liability company (LLC) is a hybrid structure that was created to provide business owners with the liability protection that corporations enjoy while allowing earnings and losses to pass through to the owners as income on their personal tax returns.

The advantages? This is perhaps most popular structure for small businesses since it has fewer legal requirements and many of the same benefits as an S-corp. Under an LLC, members are shielded from personal liability for the debts of the business if it cannot be proven that they acted in an illegal, unethical or irresponsible manner in carrying out the activities of the business. These types of entities are taxed almost like a sole proprietorship (if there’s one owner) or a partnership (if your company has multiple owners). Also, there is no limit to the number of owners and the entity is governed by a series of operating agreements.

The downside: Yes, it is more expensive to create an LLC than a sole proprietorship or partnership, but hey- maybe it’s worth it.

How to incorporate your small business:

The process of incorporating your business varies by state. Becoming an LLC can be done fairly simply via your state website. Alternatively, you can work with a business lawyer. Forming an S Corporation or a C Corporation gets more complex, so you may want to enlist the help of an expert. To learn more about whether an S-Corp or LLC is the right structure for your business, it’s a good idea to consult with an attorney or tax advisor.

Disclaimer: This material has been prepared for informational purposes only. It is not intended to provide and should not be relied on for tax, legal, or accounting advice. We suggest consulting with your tax, legal, and accounting advisor before engaging in any transaction.