Although it is possible to conduct business as a sole proprietor or general partnership without any formal incorporation, it is generally a good idea to incorporate a business as a corporation or LLC. There are a few reasons why creation of a corporation or LLC is important.
Limit Personal Liability
A corporation or LLC will limit the personal liability of the owners of the business to the extent of their investment. This is often seen as the most important reason to incorporate a business. If you do not incorporate a business, then a creditor will have access to the owners’ personal assets if business assets are insufficient to pay creditors.
Here is an example to illustrate how this could play out: Steve-Do-Gooder and Jane-Kind operate Save-The-World Nutrition as a partnership without any formal incorporation. They sell organic nutrition bars as a means to support low-income communities. Greg-the-Grump eats a bar, gets sick, and ends up in the hospital. Greg-the-Grump sues the partnership and the individual owners and wins a large sum of money for medical costs and pain and suffering. Because the partnership does not have limited liability status, Greg-the-Grump is able to collect money from the partnership and is also able to place a lien on Steve-Do-Gooder’s house and collect money from Jane-Kind’s honeymoon savings. If Steve and Jane had created an LLC or corporation, then Greg only would have been able to collect from the partnership’s assets, and not from their personal assets. This limited liability protection is the main reason why businesses choose to form a corporate or LLC structure.
Name Recognition & Prevent Confusion
In California, if you incorporate a business as a corporation or LLC, then the business name will be posted on the Secretary of State’s website and nobody else will be permitted to do business in the State under the same name. On the other hand, if your business is operating as a sole proprietorship or partnership without any filings with the State, then you will have to file a fictitious business name statement in the county where your principal place of business resides (unless your business is operating under your individual name). It is unlikely that others seeking to do business will check every county’s recorder’s office to see if others are using the same business name. Thus, to effectively reserve your business’ name and prevent confusion to consumers, you would need to file a fictitious business name statement in every county where you do business.
Investors are much more likely to put their money into an established business entity than into a business that is not separate from the individual owners. It is important to note that a corporation is generally viewed as the preferred entity for businesses seeking investment from outside equity investors. Thus, if Save-The-World Nutrition is planning on seeking impact investment in the form of equity, it would be a good idea for Steve and Jane to create a corporation (and based on their social mission, a good corporate form would likely be a benefit corporation or flexible purpose corporation).
Formation of an LLC or corporation also carries the benefit of appearing more legitimate to consumers, partner organizations, vendors, and others. This factor may carry more or less weight in different circles but it is certainly something to consider. Additionally, if you need to demonstrate proof of income to get a loan, to rent an apartment, or for other reasons, it often appears more legitimate to have a paystub from an established entity.
In certain situations, owners of a business may enjoy tax benefits by establishing a formal entity. In particular, at times, creation of an “S-Corporation” allows owners to split incoming money as salary and profits and pay less taxes on the profits portion. But it is also important to note that creation of a “C-Corporation” (the default corporate form) has the tax detriment of being subject to “double taxation.”
DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal counsel advice. This article may constitute attorney advertising under applicable state laws.