Speaking from personal experience, I can tell you that there’s a lot of hassle in moving up from a sole proprietorship or partnership to the status of a corporation. There are solid business reasons for changing your corporate status, but there are new requirements that come with the change.
Simply filing for incorporation in the first place takes time and money. You have to have shareholder meetings and record a summary of what transpired in what’s called the corporate minutes book. You have to have a formal board of directors meeting once a year and record decisions made. (Often in a small company the shareholders and the board members are the same people, but you still have to hold the meeting.) You have to memorialize in written form any contractual obligations. And you absolutely, positively must attend to these annoying details or you risk losing your protection.
There is another option for small business owners: the limited liability company, or LLC. LLCs are not taxed at the “entity level” and therefore eliminate the double taxation problem that having a corporation creates. In an LLC, the profits of the business pass through to the members. This happens in two ways: through guaranteed payments, which are treated like earned income (subject to self-employment tax), and profit distributions (not subject to self-employment tax). Having the earned vs. unearned income option and being able to control it gives you and the other members a lot of flexibility when it comes to nuts-and-bolts financial issues such as taxes, health insurance, and retirement plans.
The most important benefit, however, is that one of the members, called the managing member, enjoys the same protection against personal financial loss as a corporation. Also, LLCs are not subjected to nearly as much paperwork. Once you figure out all the ins and outs of the structure, it’s relatively easy to manage on a quarter-by-quarter basis.
While LLCs seem to be the perfect structure for a small business, with protection against disaster and a lot of ways to minimize taxation, there are a couple of substantial drawbacks. The first is that LLCs are still perceived as newcomers to the financial world and perhaps a little exotic. Having an LLC instead of a “real” corporation can potentially create a bad impression with lenders and large corporate customers, particularly in today’s financial climate, where caution is the rule. And on a practical level, the tiny details of LLCs haven’t been worked out as well as they have been for corporations; so lawyers often end up billing more hours to get things done when an LLC is involved.
Here’s the bottom line: If you haven’t considered restructuring your business from a sole proprietorship or partnership to a corporation or LLC, you should. Particularly in the case of incorporation, you gain financial protection and a certain amount of prestige. But you need to spend some serious time with legal and financial experts before you make the decision.