Incorporation: Is it Right for Your Small Business?

Small business owners often incorporate in order to protect their owner's personal assets from being garnished during a lawsuit. Although this is the primary advantage of incorporation, there are other important considerations, both positive and negative. There are three different ways for incorporating a small business: A C corporation, limited liability company (LLC), and an S corporation.

A C corporation is the most common type of incorporation for small businesses who are trying to attract venture capital from investors. There can be an unlimited number of individual shareholders in a C corporation. Many investors hold the belief that a C corporation is the most professional kind of corporate entity. However, C corporations must abide by a host of formal requirements that sole proprietorships are not bound by. These requirements include holding regular meetings of a board of directors, establishing corporate bylaws, and creating formal paperwork detailing the operations of the corporation. In addition, C corporations are taxed individually, so business owners must pay corporate taxes in addition to personal income taxes.

A limited liability corporation (LLC) is a fairly new type of corporation where corporate profits are distributed according to the wishes of the members, rather than being based on shares owned. Owners of an LLC must pay tax only on their personal income, and do not have to pay corporate taxes. And there is no upper limit on the number of members that can belong to the LLC, and anyone in the world can be an owner, even people who are not U.S. citizens. However, an LLC cannot issue stock or become a public corporation, and owners may be required to pay self-employment taxes.

An S corporation is a mixed bag combining elements of both a C corporation and an LLC. Profits are distributed based on the ownership of the corporation, and partners involved in an S corporation are taxed only on their personal income, and do not have to pay corporate taxes. However, S corporations are limited to only 100 shareholders, and every shareholder has to be a citizen of the United States.

Recent statistics have shown that only about half of the self-employed people in the United States have incorporated their businesses. But many economists feel that even with small businesses, a corporation has a higher rate of success than a sole proprietorship. Academic research has shown that corporations have increased profitability, sales growth, employment rates, and other advantages over sole proprietorships. The biggest advantage lies in protecting legal liability. If a sole proprietor is sued, personal assets can be targeted and lost. But a corporation will be liable for only the assets the owners have put in.

Some small business owners feel that their business is not significant enough for them to worry about legal liabilities. And many very small businesses may indeed not be good candidates for incorporation because doing so can be complex and expensive. But for businesses such as eBay sellers, shipping products around the globe can cause legal problems that may be more costly and complex than incorporation itself. And where incorporating used to cost thousands of dollars and require a lawyer's help over the course of a couple of weeks, businesses can now go online and get themselves incorporated in a matter of hours for only a few hundred dollars.

The default option for many small business owners is to not incorporate and run as a sole proprietorship simply because it is more convenient, and there are no legal hoops to jump through, and things are easier at tax time every year. But before automatically discounting the option of incorporation, every business owner should at least look into the possibilities, weigh the pros and cons, and decide whether or not incorporating is a good idea.