While both LLCs and corporations have their merits, the advantages of incorporating your small business are compelling.
Starting a business can be exciting, but it comes with numerous decisions. One of these is determining the right legal structure. Two of the most popular options for a small business are Limited Liability Companies (LLCs) and corporations. While both offer various advantages, you will soon discover why incorporating your small business may be the better choice.
The Basics: LLCs vs. Corporations
Limited Liability Company (LLC)
An Limited Liability Company (LLC) combines elements of both a partnership and a corporation. Owners of an LLC, known as members, enjoy limited liability protection, which means their personal assets are typically shielded from business debts and lawsuits. LLCs offer simplicity in management, flexible tax options, and fewer regulatory requirements compared to corporations.
Corporations are distinct legal entities from their owners, also called shareholders. Like an LLC, a corporation provides limited liability protection. However, corporations are subject to more formalities. These include but are not limited to holding regular meetings, maintaining detailed records, and adhering to specific governance structures.
Reasons to Incorporate Instead of Forming an LLC
Limited Liability Protection
When you incorporate a small business, it becomes a separate legal entity, distinct from its owners. This means your personal assets, such as your home and savings, are shielded from business debts, lawsuits, and liabilities. In other words, your wealth remains safeguarded if your business faces financial trouble or legal issues.
On the contrary, while you do have some protection in an LLC, it may not be as robust as that provided by incorporation. In some cases, the personal assets of LLC owners (also known as members) may still be at risk, particularly if the LLC is not properly maintained or if the members engage in negligent or wrongful activities.
Enhanced Credibility & Perceived Stability
A corporation is often seen as a more stable and enduring entity than an LLC or sole proprietorship. This perception can open doors to capital and investment opportunities that might not be available to unincorporated businesses.
When it comes to seeking financing or partnerships, many investors and organizations prefer to work with corporations because they have established governance structures and reporting requirements. Incorporation demonstrates a commitment to professionalism and longevity that can instill confidence in potential stakeholders.
Easier Access to Capital
Incorporating your small business can make it easier to raise capital. In fact, corporations have several advantages in this regard. These may include the following:
- Issuing Stock: Corporations have the option to issue stock to raise capital. This means you can sell shares of your company to investors, which can be an efficient way to secure funds for expansion. In contrast, LLCs typically do not have this option, making it more challenging to attract investment.
- Attracting Investors: Investors often prefer to invest in corporations because they have a clear ownership structure and can easily transfer ownership through stock purchases. This allows you to attract investors and grow your small business with external funding.
- Borrowing Capacity: Corporations generally have better borrowing capacity. Banks and financial institutions are more likely to offer loans to corporations because they have established credit histories and are seen as lower-risk borrowers than sole proprietors or small partnerships.
Corporations have an independent legal existence, unlike sole proprietorships and partnerships, which are closely tied to the individuals who own them. This means the small business can continue to exist even if the original owners decide to leave or sell their shares.
Perpetual existence can be advantageous in terms of long-term planning and sustainability. It allows for smoother transitions in ownership and management, ensuring that the business can continue to operate seamlessly in the event of changes among the shareholders or directors.
Access to Government Contracts and Grants
Government agencies often prefer to do business with incorporated entities. If your small business plans to pursue government contracts or grants, incorporating can open doors to these opportunities. Many government programs require businesses to have a corporate structure to be eligible for consideration.
By incorporating, you can access a wide range of government contracts and grants, potentially leading to significant revenue streams for your business.
Tax Flexibility & Planning
While LLCs offer pass-through taxation, corporations can also provide tax advantages in certain situations. For instance, a corporation may be able to deduct a wider range of business expenses, such as healthcare benefits for employees or retirement plans.
Additionally, a corporate structure may provide more favorable tax treatment if you plan to reinvest profits into the business. You can opt to retain earnings within the corporation and potentially benefit from lower corporate tax rates.
Attractive Employee Benefits
Corporations can offer various retirement plans, stock option programs, and employee stock purchase plans, which can be valuable tools for attracting and retaining top talent.
Furthermore, incorporation can make it easier to implement tax-advantaged employee benefit plans, such as 401(k) plans with higher contribution limits and more flexible options.
For LLCs, providing similar employee benefits may be more challenging and less tax-efficient, limiting your ability to compete for skilled employees.
Easier Exit Strategy and Business Sale
At some point, you may decide to exit your small business by selling it or merging with another company. Incorporating your business allows you to simplify the process of selling your business or transferring ownership when the time comes.
Corporations have a well-defined ownership structure, which makes it easier to transfer ownership by selling shares. Having a corporate structure also has the potential to attract potential buyers or investors who prefer the clarity and stability that corporations offer.
Potential Drawbacks to Consider
Complexities and Formalities
Unlike the relatively straightforward process of forming an LLC, incorporating a business involves a more intricate set of legal procedures and ongoing obligations.
Corporations are required to adhere to strict governance and reporting requirements, including:
- Holding regular board of directors and shareholder meetings.
- Maintaining detailed records of these meetings.
- Filing annual reports with the state.
- Complying with various regulatory and compliance requirements.
These formalities can be time-consuming and require professional assistance, such as hiring an attorney or accountant. Small business owners who prefer a streamlined and less bureaucratic approach may find the administrative burden associated with incorporation off-putting.
By default, corporations are taxed at corporate and individual levels when profits are distributed to shareholders as dividends.
At the corporate level, profits are subject to corporate income tax, which can be relatively high depending on your jurisdiction. Then, when dividends are paid to shareholders, those dividends are taxed again at the individual level as part of their personal income.
This double taxation can lead to a higher overall tax liability for the corporation and its shareholders. While some corporations can elect to be taxed as S corporations, which allows for pass-through taxation similar to an LLC, this comes with eligibility requirements and restrictions.
Limited Personal Control
In a corporation, ownership and control are typically separated. Shareholders elect a board of directors, who then make strategic decisions and appoint officers to manage the day-to-day operations. This separation of ownership and control can lead to a loss of personal control for small business owners who want to be heavily involved in every aspect of their business.
In contrast, an LLC offers more flexibility in management and allows members to have a more direct say in the company’s affairs.
More often than not, corporations are required to disclose more information about their operations and financial status than LLCs. This transparency can result in less privacy for business owners. If privacy is a significant concern for you, an LLC might offer more discretion in terms of sharing financial information with the public.
Making the Right Choice
Choosing between forming an LLC and incorporating will depend on various factors:
Incorporation may be the better choice if you have ambitions to raise significant capital, issue stock, or eventually sell your business. Corporations offer the necessary structure and credibility to attract investors and facilitate these transactions.
An LLC offers pass-through taxation, while a corporation can provide tax advantages in certain scenarios. Always consult a tax professional to determine which structure aligns best with your tax strategy and financial goals.
Size and Complexity
Smaller, closely held businesses may find the simplicity and flexibility of an LLC more appealing. Conversely, larger businesses with complex ownership structures may benefit from the formalities and structure of a corporation.
Funding and Investment Plans
Incorporating might make more sense when you plan to seek external funding from investors and venture capitalists or go public through an initial public offering (IPO). Investors often prefer corporations due to their established governance and transparency.
While both LLCs and corporations have their merits, the advantages of incorporating your small business are compelling. From robust limited liability protection to enhanced credibility, access to capital, and simplified ownership transfers, incorporation offers a host of benefits that can position your company for growth, stability, and long-term success.