The Implications of Incorporating Your Business and When to Make the Leap

To incorporate or not to incorporate? That’s the first question. Choosing which business structure suits your company comes next. We break down your options.

Running a business isn’t as simple as providing a great product and paying fair wages. Sometimes, things get complicated and as your business grows you’re likely hearing the word “incorporate” thrown around a lot. But what exactly does it mean to incorporate? What are the implications? And should you even go through all the trouble?

What does it mean to incorporate?

When you incorporate your business, you set it up as a separate legal entity from yourself. If the company goes under and you can’t pay your suppliers or business debt, your creditors can’t come after your personal assets—just your business assets.

Ever wonder why millionaires can still be rich after their business completely fails? Well, this is partly the reason why. When your company is a separate entity from you, your personal assets, like your house and your car, are not on the line.

On the other hand, if you are running things as a sole proprietor your personal finances and business finances are mixed. This makes your personal assets fair game if you fail to meet your business’s debt obligations. If a sole proprietor starts an e-commerce store and takes out a loan to grow the business only to run into some bad luck, they are personally tied to that debt.

The pros of incorporation

Aside from the separation of your personal and business expenses, incorporating gives you access to tax benefits reserved for businesses.

Let’s say your business has a fantastic year, but you don’t need a lot of the business’s money to meet your personal expenses. You can keep that money in your business, thereby lowering your personal income for the year and the income tax you are required to pay. Since businesses benefit from a lower rate and nice tax breaks, it’s more tax efficient to leave your money there.

As a sole proprietor, your business income is your personal income. So if you have a fantastic year, you’re going to have to pay a higher tax rate.

The cons of incorporation

It’s a pricey process and definitely something that will require professional help beyond that of an accountant.

“You want to involve a tax specialist and an attorney when you make the decision to incorporate, not just an accountant,” advises Quan Ly, a Chartered Professional Accountant (Canada) at McRally, who also holds a Certified Public Accountant designation and Masters in Taxation in the US.

Incorporating also provides some legal protection that isn’t afforded to sole proprietors, but that doesn’t mean business owners can completely pass the buck, particularly when they are a smaller size.

“It is important to understand the various roles that you will be taking on when you are incorporated,” says Ly. “Each role (director, officer, shareholder, etc.) has its own responsibilities and in many small businesses, you need to wear all three hats. You and your company can be exposed if you fail to properly fulfil your responsibilities under each role.”

When should I incorporate and what are the different corporate structures?

Of course, the next question is when should you incorporate. The simple answer is: Once you start making a significant amount of money.

Exact figures vary, but generally speaking, experts recommend waiting until you reach $60,000 to $80,000 a year in revenue. Then again, this is when it counts to bring in professional help to evaluate your business’s specific situation.

To further complicate matters, there are several different business structures that companies can choose from. The most relevant to small business owners are sole proprietorships, partnerships, and corporations (in Canada), and sole proprietorships, partnerships, limited liability companies (LLC), and corporations (in the United States).

A sole proprietorship is run by a single individual and there is no legal distinction between the person and their business. A corporation is the opposite. It’s a completely separate legal entity.

In between these two fall other legal structures that business owners can choose like a partnership or an LLC. A partnership is a non-incorporated structure that splits the responsibility and debt obligation between two people or more. This makes having a partnership agreement extremely important to avoid disputes later. A limited liability company is a hybrid solution that combines the protection of a corporation with the flexibility of a partnership.

 

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Exact figures vary, but generally speaking, experts recommend waiting until you reach $60,000 to $80,000 a year in revenue. Then again, this is when it counts to bring in professional help to evaluate your business’s specific situation.

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So which should you choose?

“It depends on the business, the risk profiles, their objectives (i.e., growth and exit strategies), the capital structure, whether there are other investors or partners in the business,” says Ly.

It’s no wonder he recommends hiring an accountant and an attorney: Businesses are complicated financial and legal beasts. That said, he does provide some context.

“Many people will default to a corporation, so I would say that’s one of the most common structures. In the U.S. some businesses may opt to operate under an LLC. Under an LLC, the profits could flow directly to the members personally, but you can choose to be treated as a corporation from a tax standpoint by filing an election. The legal benefits of an LLC are similar to a corporation, however, the flexibility from a tax perspective is why you’ll see a lot of LLCs.”

Every business differs and as your company grows it is important to touch base with the right professionals. Considering your different options and choosing the right legal structure for your business can protect both your company and your personal wealth.

Thinking about hiring some financial help? We cover how bookkeepers and accountants help you understand your business.

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