biz ladies 09: sole proprietorship vs. incorporation

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today i’m thrilled to have andrea baxter of smart cookies and bratface marketing on d*s giving us the lowdown on sole proprietorship vs. incorporation. if you’re running a small business, considering what type of company you will be had no doubt crossed your mind before- and it’s not always easy to know what option is best for you. today andrea is here to break it all down, including the pros and cons of each type of business. even if you’re just getting started, this is really valuable information to have in your pocket so i hope you’ll check it out. thank you again to andrea for sharing her time and her advice with us!

CLICK HERE for the full article after the jump!

Getting the Dirt on Sole Proprietorship vs. Incorporation

When I started the Smart Cookies with a fabulous group of 20 and 30-somethings, we didn’t realize how very green we were when it came to running a business. We were too worried about making a profit and figuring out our niche in this competitive business world. But as time went by and the business grew, we learned things quite easily and quicker than expected. What we did know, was that we wanted to protect the brand we had created and we knew the only way to do this was to hire a lawyer who could give us the best advice possible, and to help us formalize and legalize the business so we were protected as well. We were quickly exposed to the legal side of business and had to learn…..fast!

By the time I launched my other business (on my own) 3 years later –Bratface Marketing – I felt like a seasoned pro. As a woman in business I wanted to share my thoughts and experiences on what I had to learn when it came to this tricky legal industry. It always makes it easier for me to learn something when you can read through all the legal jargon and get to the point so you know what is best for your company and move start moving forward.

This seems like a very dry and uninteresting topic but in fact, it’s very much the opposite. The importance of Sole Proprietorship vs. Incorporation doesn’t really apply to anyone until they find themselves running their own business and scratching their heads as to what the differences are between the two and determining which is best for their company. This can be a costly thing to do for any business but it will be the best (and smartest) decision you make, especially as you grow. If you can have the basic foundations laid down when it comes to the legal side of your business, you will be one step ahead and at ease knowing you are protected.

Below I have outlined what sole proprietorship and incorporation means as well as advantages and disadvantages for each. Legalities and jurisdictions will vary depending on which US state or Canadian province you live in, so it is important to consult with a legal professional to get all of the details based on where you live.

In a nutshell, a sole proprietorship is a business of one without corporation or limited liability status. The individual represents the company legally and fully. Yes, that means you. This means that all of the financial benefits of the business belong to you personally. The assets of the business are yours to do with as you please; and the profits of the business are your profits and are reportable as your personal income. Seem risky to put your financial self on the edge? Well, this would be the best option if you want to avoid all the fees and legalities that come with incorporating your business. Less paperwork and fewer people involved.

Here are some of the advantages of a sole proprietorship:

1. Quick Tax Preparation: filing your taxes is generally easier than with a corporation. You can file an individual tax return including your businesses profits and losses and self-employed tax implications will apply.
2. Lower Start Up Costs: For many start up companies, limited capital is common and always cheaper than starting up a corporation. It is also very common to have a lawyer involved in starting up a corporation whereas a sole proprietorship you don’t.
3. Ease of Money Handling: handling the money in a sole proprietorship is a lot easier than with a corporation because there is typically no payroll to be set up or legal structures. To keep it simple, set up a separate business bank account from your personal.

With advantages, there also come disadvantages of a sole proprietorship:

1. Personally liable: this is the biggest risk any business owner takes as a sole proprietor. Every personal asset, bank account etc you have is at risk if the business fails to succeed or if you are sued for any reason. Your business doesn’t exist as a separate legal entity. All your personal wealth and assets are linked to the business.
2. Difficult to raise capital: growing a small company from scratch will require some capital to start up, in most cases. Outside companies and potential investors will take you more seriously if you are a corporation.
3. Lack of financial controls: The structure of a proprietorship won’t require financial statements and maintaining company minutes as a corporation. This can result in the end of your small business. No matter the legal structure or size of your business, take time to set up the proper financial statements for your company. Profit and loss, balance sheets and ledgers are all important documents you should have created and stayed on top of monthly. You can hire a bookkeeper/accountant to manage these and tabulate all of the numbers for you for a small fee.

By incorporating a company you become a shareholder (meaning you own a share of the business if you have multiple business partners), your liability is limited to the value of the cash and property that you contributed to the company. Your personal assets, including your personal bank accounts, cars, and real property, are “shielded” from creditors. Basically, your personal assets are protected in case anything was to happen with the business.

Regardless of what you decide to do, you should seek the assistance of professional legal, tax and financial advisors before making a decision. Incorporating is not appropriate for every business; however, if, by incorporating, you can decrease your tax liability, ensure the retention of your personal assets in spite of the success or failure of your business, and do all of this while maintaining flexibility and control over the direction that your business will take, you will be a success.

Here are some of the advantages to incorporating your business:

1. Owner Liability: Once a company becomes incorporated, the owner’s legal liability is limited. The corporation becomes a separate entity and would be legally liable for any debts or activities. In order to protect yourself and maintain limited liability, your corporation must follow certain procedures. These may include:

  • Holding shareholder and director meetings (including AGMs)
  • Maintaining corporate records (financial and legal)
  • Documenting major corporate decisions such as: issuing stock, purchase or sale of real estate, or borrowing money
  • Stock options, if applicable

2. Management Structure: An incorporated company has directors, officers and shareholders. Directors are normally listed on your articles of incorporation and are responsible for choosing the officers of the company. Each of these groups of people has defined roles and responsibilities. This allows you to create a management structure and chain of command as well as determining specific areas of responsibilities. For very small corporations, one or two people may be in all of the roles. If you are an organized businessperson, this is a huge benefit.

3. Tax Advantages: Some businesses enjoy lower tax rates under the incorporated designation than they would if they operated as a partnership or sole proprietorship. For example, business owners can adjust the salaries they pay themselves in ways that impact on the corporation’s profits and, subsequently, its tax obligations. It can also be easier for a business to invest in pension plans and other fringe benefits as a corporation because the cost of these benefits can be counted as tax-deductible business expenses.

With advantages, there also come disadvantages to incorporating your business:

1. Regulatory and Record keeping Requirements: Corporate operations are governed by local, state, and federal regulations to a greater degree than are other businesses. Because there are more legal, financial and administrative documents to file and keep track of, you have certain regulatory rules to follow.

2. Added Cost of Doing Business: Regulatory and record keeping guidelines and requirements often make it necessary for corporations to make additional investments (in accounting staffing, etc.). In addition, there are fees associated with incorporating that business partnerships and sole proprietorships are not subject to and they can be costly and take time.

3. “Double” Taxation: People who are owners of a corporation, and who also work as an employee of the business, can receive financial compensation in two different ways. In addition to receiving a salary or wages for work performed, the owner may also receive a dividend or distribution on the stock that he or she owns. Any distribution of income to stockholders via dividends is taxable, however, if the corporation is organized as a “C corporation.” This is sometimes called “double taxation” in recognition of the fact that such income has in reality been taxed twice, first when the corporation paid taxes on its profits, and secondly when the dividends were distributed. Companies that register as an “S corporation,” however, are able to avoid this added tax.

4. Separation of Finances: While incorporation provides significant protection of owners’ personal assets from repercussions of business downturns, it also means that a business owner is not allowed to tap into the corporation’s account for assistance in meeting personal debts. What is the businesses assets stays that way and your personal assets and debts are maintained separately.

When we started the Smart Cookies, it was best to incorporate the business because there were 5 of us co-founders and none of us wanted to put our personal assets at stake with the business. In addition, we always treated the business like a formal business from the start, so having the proper legal documents, trademarks, financial documents, etc in place were essential and important for us. Our business is mostly media driven in both the USA and Canada, so we wanted to protect ourselves properly.

With Bratface Marketing, I am the only employee and I mostly do business in Canada, so I chose sole proprietorship. Plus funding was limited and I didn’t have as much capital up front as I did with the Smart Cookies. It has proven to be easier for me when it comes to tax season as well. If the company grows substantially in the next few years, I would most likely re-evaluate this and possibly become incorporated.

One final note: as a woman in business, especially if you own a business, there comes a lot of responsibility, smarts and not to mention the hardships. So be sure to ask the (sometimes)
obvious questions about the differences between the two. The more educated you are on the topic, the greater likelihood of making the best decision possible for your company. But the rewards and lessons learned are priceless. Surrounding myself with mentors who could offer solid advice and point you in the right direction is worth it. Often these people will solicit
advice for free, which is great when you are in the start up phase and have little funding available.

Judith

thank you, andrea, for this incredible information! it’s so hard to sort through all of the legal terminology and regulations when you’re running a small business!

do you have a favorite site or resource that you have found particularly helpful? especially a canadian one?
thanks again!

Erika - 2byDesign

Wow, this couldn’t have come at a better time! I keep bouncing back and forth for my writing biz and I just need to make a decision. Story of my life!

Sianna

Thanks, this is a very clear explanation of incorporating vs. sole proprietorship. I just decided to incorporate my business as a Limited Liability Company through http://www.delawareinc.com. It was really easy and I am so glad I did it, I sleep better at night.

Pamela S.

I once had a client that turned out to have a very litigious history. Of course I did not find out about this ongoing history of suing vendors until I was sued by this client for what amounted to made up charges. I spent a small fortune defending myself against “damages” that were completely fabricated.

I found out the hard way. Sole proprietorship is NOT the way to go. It leaves your personal assets wide open. I would recommend speaking to a good lawyer about such matters when starting up any business. Not all people turn out to be good or nice people and it can be financially devastating if you don’t CYA in a legal manner…even if you have done absolutely nothing wrong.

Lydia, Clueless Crafter

Andrea, you are right to encourage women to ask the questions.

My husband and I are considering going in on a company together. Any big caveats to to keep in mind as we do this?

Go for it Erika! And so sorry you got taken Pamela. My mother owned her own business and it almost happened to her!

Treehouse Collective

When my business first began 3 years ago I was primarily dealing with items intended for children and decided to incorporate as an LLC to protect myself from the high liability factor. The yearly LLC fee has been a tough pill to swallow, and I have incurred other fees associated with the LLC that I wasn’t expecting, like the bi-annual renewal of the Statement of Information. Since then, I have discovered that my stationery line is more successful and I want to focus my energy in this area of less liability. Therefore, I have decided to dissolve the LLC and convert to a sole proprietorship in the new year, always having the option to reincorporate if it ever seems necessary.

A lot of changes, and a continual assessment of needs, but being armed with information such as that presented here makes these decisions so much easier. Especially since I remember how difficult such information was to find when I first started. Thank you! Keep it coming : )

Jennifer

Andrea, this article was so helpful. As a creative mind I think many of us find it hard to plow through information on the US Government’s website with regards with business options. I myself thought I was going to go one route – and that was after talking to a few people who had started their own companies. I decided to wait and am now glad I did as you have made it much more clear which would better suit my situation.

For myself and all other creatives who need things written in laymans terms, THANK YOU!

Ariel

Very helpful information. When I started my jewelry business last year (www.arielgordonjewelry.com) I decided to set up an LLC. I used http://www.legalzoom.com to help me file all the paper work and it was a fraction of what a lawyer would cost. Definitely worth checking out.

Dawn at MairzyDozy

Thank you Andrea! My sister and I just incorporated our business last month (LLC). We used lawinc.com. They were great. We are nervous and excited about being a new entity. We still have so much to learn, and I appreciated how you laid out this information so clearly.

Heather

For most people planning to start a small business, an LLC is a more appropriate and practical choice. (Assuming you’re not planning public stock offerings, etc.) An LLC is a corporation that functions as a hybrid of a sole proprietorship and a corporation. In essence, it combines the advantages of each type of entity. An LLC is relatively easy to set up and a lawyer is not necessary. (I say this as a lawyer.) Many states have websites that will walk you through the process, as well as links to organizations that offer free business advice and resources.

Allison

If you operate your business as a sole proprietorship, do you need a basic business license?

Wills Online

This is a tricky one however with support organisations such as SeedCamp out there i think it is easier to trade solely.

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