One of the first business decisions an owner makes is whether to operate as an incorporated business or an unincorporated business. An incorporated business is one registered as its own legal entity, separate from its owners, such as a corporation or limited liability company (LLC). Legal separation protects the owner’s personal assets in case of legal or financial trouble, since the business’s assets are at risk instead.

An unincorporated business (e.g., sole proprietorship, partnership) doesn’t have legal separation, so the owner is personally liable for business debts and obligations. While unincorporated businesses can offer flexibility and ease of entry, they come with greater personal risk for the owner.

Below, we cover the differences between incorporated and unincorporated businesses, including tax implications, investment potential, and ongoing administrative requirements.

What’s in this article?

• How liability differs for incorporated and unincorporated businesses
  
• How do taxes differ for incorporated and unincorporated businesses?
  
• What are the ownership and investment implications?
  
• How to transition from an unincorporated to an incorporated business
  

How liability differs for incorporated and unincorporated businesses

In an incorporated business, the owners have limited liability. If the business faces lawsuits, debts, or other liabilities, only the business’s assets are at stake. The owners’ personal savings, properties, and investments are safe. Limited liability is one of the main reasons people choose to incorporate, especially in industries where lawsuits or large debts could be a risk.

Unincorporated businesses don’t have this legal protection. If the business faces a lawsuit, debts, or other liabilities, creditors can seize the owner’s personal assets to satisfy the claim.

How do taxes differ for incorporated and unincorporated businesses?

Incorporated businesses can access some tax-saving tactics, such as qualified dividends, that are generally taxed at lower rates. Conversely, unincorporated businesses benefit from simplicity and pass-through taxation.

Here are the taxes each might pay:

Incorporated business taxes

Incorporated businesses are legally separate from their owners, which typically leads to more complex tax filings.

• C corporations (C corps): C corps are taxed as separate entities and must pay corporate tax rates (21% in the US). The owners of C corps pay double taxation if profits are distributed as dividends, although small businesses might avoid this by keeping profits within the business.

• S corporations (S corps) and LLCs: S corps and LLCs avoid double taxation with pass-through taxation, where income flows directly to shareholders or members.

Unincorporated business taxes

Unincorporated businesses aren’t legally separate from their owners, so the owners don’t pay corporate tax rates. Instead, they report all profits and losses on their personal tax returns and pay taxes at their personal income tax rate. This pass-through taxation avoids double taxation, but business income can push owners into higher tax brackets.

Unincorporated business owners also pay self-employment tax on their business earnings, which covers Social Security and Medicare.

What are the ownership and investment implications?

When deciding whether to incorporate your business or remain unincorporated, it’s worth considering the implications for ownership and investment. Incorporation is generally the best choice for entrepreneurs seeking flexibility in ownership and access to investors. However, remaining unincorporated might suit single owners or small partnerships that prioritize simplicity and don’t need outside capital.

Here’s a closer look:

Ownership

Incorporated businesses (corporations or LLCs) enable more flexible ownership. Corporations can issue shares, which makes it easy to add or transfer ownership stakes, even to outside investors. This flexibility appeals to founders who want to bring in investors or eventually sell the business. LLCs are also flexible and often allow multiple members with defined percentages of ownership.

Unincorporated businesses (sole proprietorships or partnerships) are usually tied closely to their owners. For sole proprietorships, the business is inseparable from the owner, so transferring ownership requires selling the entire operation, which can be complicated. Partnerships enable shared ownership, but splitting or restructuring ownership can be complex.

Investment

Incorporated businesses have a big advantage when it comes to raising capital. Corporations can issue stocks, which means they can raise funds from multiple investors—even publicly if they have an initial public offering (IPO).

Unincorporated businesses typically lack these options. Since they can’t issue stock, they usually raise capital by taking on debt or bringing in partners.

How to transition from an unincorporated to an incorporated business

If you want to transition from an unincorporated to an incorporated business, decide which new business structure you’d like to adopt. If your business is a sole proprietorship, an LLC might be the easiest transition. But if you want future investors or a shareholder setup, consider a C corp or S corp. (If you choose an S corp, file Form 2553 with the IRS.)

When incorporating your business, consult an accountant and attorney to catch overlooked legalities and unexpected tax implications. This applies especially when transferring high-value assets or existing client contracts.

Here’s a step-by-step guide to incorporation:

Reserve the business name and register with your state

First, reserve your business name (if needed), then file articles of incorporation or organization with a state agency, usually a secretary of state’s office. Each state has specific requirements, so check for nuances, such as publication requirements and additional filings.

When you file, specify the share structure (number and types of shares for a corporation) or membership interests (for an LLC). This impacts future financing and ownership stakes.

Transfer assets and intellectual property (IP)

If you have assets such as equipment, inventory, and IP (e.g., patents, trademarks), create a bill of sale that formally transfers these to the new entity. This creates clear ownership records for possible future audits.

If the business has developed IP, draft an assignment agreement to move all trademarks, copyrights, or patents from yourself to the corporation or LLC. This ensures the business—not you—owns the IP.

Draft shareholder agreements or operating agreements

For a corporation, develop a shareholder agreement outlining rights, roles, and responsibilities. For LLCs, create an operating agreement that defines each member’s stake and profit distribution method. These agreements are important if you’re bringing in new partners or investors. Clarify exit or buyout terms in these agreements to avoid costly legal disputes later.

Apply for a new Employer Identification Number (EIN)

Apply for a new EIN from the IRS, since the new corporation or LLC is legally distinct. You will use this EIN for all tax documents, employee payroll records, and loan applications.

Open new bank accounts

Open a new bank account specifically for the corporation or LLC. If you have a merchant account for processing payments, establish a new one under the new business’s name to ensure income and expenses are clearly separate for tax purposes.

Reassign contracts and vendor accounts

Review current client contracts and vendor agreements. If your current agreements are in your name, draft and send an assignment of contract notice to transfer these agreements to the corporation or LLC. Some clients or vendors might need to sign off on this transfer.

For important contracts—such as large clients and long-term leases—re-sign agreements directly under the corporation’s or LLC’s name to ensure continuity. Review and renegotiate terms, if needed.

Notify tax authorities and update licenses

Notify the IRS by updating any prior filings or EIN records. If it’s a C corp, your business will now file taxes separately. This often requires a corporate tax return in addition to your personal return.

Transfer any business permits to the new entity, particularly if you’re in a regulated field, such as health or finance. Some states and cities require a new business license for the incorporated entity.

File a final return and close out the old entity

If you’re shutting down a sole proprietorship or partnership, file a final tax return form for that business, and check for specific closure filings in your state.