When Is It Time to Transition to a Corporation or LLC

When many people first launch their business, they often start out as a sole proprietorship or a partnership. Sometimes the decision to use this type of structure is one of convenience—it is much easier to set up a sole proprietorship compared to a corporation or limited liability company (LLC) because there are no filing requirements and no fees.

For others, they may not realize they even have a “business” until they pay a visit to their tax preparer and have to fill out a Schedule C. These business owners may not have thought about which legal structure would work best or even that they should choose one. Sole proprietorship status is “automatic,” which means that some people do not consider their options beyond the default.

Once you have the kinks worked out of your business and you are making a profit, you may need to put a little more thought into what legal form the business should be using. As you grow, it may make more sense to “graduate” to a business structure that offers you more protection and benefits. Using a corporation or LLC has several benefits that you should consider as an emerging business.

Benefits of a Corporation or LLC that Work Well for Growth

  • Asset protection – Depending on the type of business you have, growth often means that you will have more clients and an increase in business assets. Corporations and LLCs offer asset protection that is helpful for businesses as they are growing. If, for example, something goes wrong and your business is unable to pay its creditors, then only the business assets will be at risk in a corporation or LLC. That is not the case in a sole proprietorship or partnership—your personal assets are on the line if the unthinkable happens to your business. While asset protection can be a big deal for any size of business, it is especially important to consider as your business grows.
  • Tax flexibility – If you are a sole proprietorship, you are a “pass-through” entity. That means that you are taxed as if you brought all of the income from your business into your own bank account. This is true regardless of whether you actually did. In a C corporation and LLC, you can choose to change that tax structure so that you are only taxed on income that actually reaches your hands. Your business may be taxed separately, but there is a much more definite separation between the business funds and your personal funds.
  • Perpetual existence – As a sole proprietorship, your business starts and ends with you. This means that if something happens to you personally, such as if you pass away unexpectedly, then your business also comes to a screeching halt. For companies where the whole family is involved, this can be a big deal. Imagine that a father and his two sons own a construction business together. The business is a sole proprietorship that functions for tax purposes under the father’s name. If the father passes away suddenly or becomes unable to run the business, his sons must work out how to deal with income and expenses on their own. Significant changes to titles, bank accounts, and anything else that is related to the business would have to change. If the company were in a business structure like a corporation or LLC, it would go on forever, regardless of whether the primary player can still run the business. Taxes and bank accounts do not have to be changed, and business can continue as usual.
  • Enhanced credibility – One practical consideration that is important for growing businesses is simply to think about how your customers view you. Will a client want to hand off a multi-million-dollar product to someone who has a sole proprietorship instead of a corporation? Maybe. But it would be far more likely that the customer would be more comfortable with a corporation. Having a business entity, with a real business address and name, enhances the credibility of the company. It tells customers that this venture is not just something that you are doing on the side for some extra cash—you are serious about it and professional.
  • Deductible expenses – As a sole proprietorship, you can deduct a variety of business expenses. In fact, most deductible business expenses do not change if you incorporate. However, there are some additional expenses that you can deduct, such as salaries and certain benefits provided to employees, that you may not have been able to do as a solo venture. Nonetheless, these deductions sometimes come as a trade-off because corporations are taxed separately as well.
  • Issuing stock and attracting investors – There is no stock in a sole proprietorship. You cannot sell any part of your business as a sole proprietorship. You might be able to sell the name or its goodwill, but the business itself is not available for sale—because it is you. Corporations have stocks or shares that can be sold off to investors or others who want to become involved in the business. It is much easier to attract investors and grow when you can offer them a part of the company itself, instead of a promissory note or other collateral.

Knowing When to Transition to an Incorporated Entity

Sometimes, simply knowing the benefits of incorporation will encourage you to make a move to an LLC or corporation. However, when to transition is a highly personal decision for a business owner. What works for one business owner may not work for the next. It also can vary widely by industry. For some industries, you may never need to incorporate; for others, incorporating immediately makes the most sense.

If you are encountering any of the following situations, you may want to consider incorporating to meet the needs related to the growth of your company.

You Are Considering Adding (More) Employees

You can employ people as a sole proprietorship, and there is no limit to the number of employees you have. However, you should be sure that you have an EIN number before hiring extra help, no matter what type of business entity you may be. An EIN (employer identification number) allows you to use that number instead of your social security number to provide your employees with their tax information at the end of the year.

Although you can hire employees as a sole proprietorship, you may not want to do so. As an employer, you are responsible for your employees’ actions. That means that if your employee harms another person or gets into an accident while working for you, you may be liable for their injuries as well as any damage to third parties or their property. Employees add another layer of risk that makes asset protection an even more serious concern.

You Have Several Independent Contractors Working for You

Many sole proprietorships choose to use independent contractors instead of hiring employees to avoid issues with liability and to cut down on costs. An independent contractor has a lot more control over his or her work and may only work for your business on a part-time or even “as needed” basis. They generally do not have set hours and use their own tools of the trade to perform their duties.

While this practice may work well, you should tread lightly in this area. In some states, you may actually have employees from a legal perspective, despite the fact that you call them independent contractors and treat them as such. If you are “misclassifying” employees, deliberately or accidentally, you can face penalties from state and federal tax authorities. As a sole proprietorship, misclassification penalties and back taxes come back on you personally, which is another reason to consider incorporating even if you are only using independent contractors.

You Are Adding Significant Assets

As businesses grow, they often need to expand by purchasing larger equipment, supplies, or even real estate. If you are considering adding an expensive asset to the business, you may want to consider incorporating. The same can be said about adding a significant personal asset as well.

Most people assume that asset protection only goes from the business to you—that is, it only protects you from losses associated with your business. However, it also works in the other direction. If you are sued in a personal capacity, and you have a sole proprietorship, your creditor can come in and take your business assets. If you have a corporation, however, and your company owns the assets, the creditor cannot take them. This may not be true of single-member LLCs in many states, but it is true for all corporations and multi-member LLCs.

Charging Order Protection

This protection is often referred to as “charging order” protection. It is particularly helpful if you know your business is growing and is going to add a large asset that could use that extra layer of protection.

You Are Looking for Ways to Reduce Your Self-Employment Tax

The self-employment tax rate is high—15.3% on the first $157,200 for 2017. That percentage covers all of your obligations relating to Social Security and Medicare that you would have split with your employer if you were not self-employed. This tax is in addition to your regular income tax rate that applies to all of your income.

If you form a corporation and decide to be taxed as a C corp, then you probably will not save much on taxes. However, if you choose to be taxed as an S corp or an LLC with a pass-through designation, then you can reduce your self-employment taxes. You can pay yourself through a salary so that the business pays half and you pay half of your Medicare and Social Security obligations, but you can also take your income in the form of dividends, which are not subject to self-employment tax. You cannot receive dividends alone if you are still running the business, however. Nonetheless, you can reduce the total amount of taxes owed by using dividends in many situations.

You Want to Attract Investors or Need Additional Capital

Some investors will be fine with providing you with funds in exchange for a promissory note. However, others want some collateral attached to their investment. Giving them a piece of the business in return for their investment shows investors that you are serious about the venture and that you are okay with them keeping an eye on your progress. You can only sell portions of your business if you are incorporated (assuming you do not want to make the investor a full-blown partner).

Being incorporated also often shows to banks or other lending institutions that your business is “real” and that it would be a sound investment for them. Simply having that “Inc.” or “LLC” at the end of your business’s name can go a long way toward raising additional capital.

You Are Nearing Retirement and Want to Transition Out

Even if you have run your business your entire adult life without incorporating, you may still want to consider transitioning to a corporation as you make ownership changes. If you are thinking about retirement and would like to leave the business to a relative or sell it, it will be much easier to make that change as a corporation. Switching ownership of a corporation often requires a bit of paperwork shuffling and voting procedures, but there is no “switching” available in a sole proprietorship because you are the business. If you want your business to continue after you are done working or pass on, then incorporating is a good idea.

LegalNature Can Help Your Business to Transition

Incorporating requires several forms that must be filed in your state. Use our business formation forms to get this process started.