Incorporation can be a smart decision for small businesses as they start to grow. Knowing when and how to do it, however, is sometimes difficult, and the process can be complicated.
Here are four (often costly) incorporation mistakes that small businesses tend to make.
1. Incorporating Too Soon
A common myth about incorporating your business is that it protects you from personal liability and, because of this, many small businesses choose to incorporate right out of the gate. There are three reasons why this is usually a bad idea.
The first reason is that the business owner is rarely as protected as she thinks she is: Corporate shareholders, especially active ones, are responsible for their actions as company representatives and can be found legally liable for damages and even face criminal prosecution. They cannot hide behind the corporate shield.
Secondly, although shareholders can find some financial protection from the debts of the corporation, lenders often require owners to sign personal guarantees before lending. This negates the benefits.
Finally, incorporation doesn’t provide a tax benefit in early lean years. In order to take advantage of your personal deductions and exemptions, you will have to pay out the corporate profits to you personally, thereby negating any benefit of the corporate tax rate.
2. Choosing the Wrong Structure
There are three basic business structures in the U.S. other than sole proprietorship, and the one you choose determines your tax treatment. The simplest is a limited liability company. An LLC provides the same liability protections as any other corporation and allows the net profit to flow through to the shareholders for tax purposes. There is less paperwork and complexity than with other structures. Meanwhile, an S Corporation can choose to be treated like a partnership for tax purposes, wherein the net profits also flow through to the individual owners for tax purposes. An S Corporation has more flexibility than an LLC.
A C Corporation is often a larger company with many shareholders. Although it benefits from the lower corporate tax rate on profits, it suffers from double-taxation on any profits paid out to the shareholders. Choosing the wrong structure can significantly affect the amount of tax you pay and the amount of paperwork you are required to maintain.
3. Falling Behind on Tax Filings
Every state has different incorporation rules and requirements for filing tax returns and information returns. Not understanding what you have to file on a regular basis or falling behind on those filings can result in penalties and can even risk your incorporation status. A more complex structure, such as a C Corporation, often requires an experienced accountant to prepare and file corporate returns and maintain minutes, adding to the expense of maintaining the structure.
4. Failing to Consult with an Accountant or Lawyer
In the past several years, the process of incorporating has become easier for a business owner to handle herself. There are many online services that will prepare the paperwork for you and file on your behalf. What they don’t offer is advice on what the proper structure is for your particular situation and what your tax planning strategies should be going forward.
Speaking with your accountant or business lawyer about the different paths you can take — and understanding what their ramifications are — can save you thousands of dollars down the road. Making incorporation mistakes can be costly and are easily prevented by seeking professional help in advance.