Unincorporated and incorporated businesses are two basic forms of business structures that each have their own set of rules, implications, and benefits.

An unincorporated business, such as a sole proprietorship or a partnership, is a business that hasn’t been registered as a legal entity separate from its owner. The business and its owner or owners are considered the same legal entity, and any debts or legal issues the business faces are the owners’ responsibility. Unincorporated businesses are often simpler to set up and operate and don’t have as many regulatory requirements as incorporated businesses, making them a popular choice for small or start-up operations.

An incorporated business, like a corporation or a limited liability company (LLC), is a business that has been registered as a separate legal entity from its owners, who are often called shareholders. Incorporation offers limited liability protection, which means shareholders’ personal assets are protected if the company incurs debt or is sued. This type of business can be more complex and costly to establish and maintain, as it requires adhering to more regulations, filing paperwork like articles of incorporation, and keeping detailed financial records.

In this guide, we’ll discuss the legal implications, tax responsibilities, and liabilities of incorporated and unincorporated businesses, as well as how to choose between the two business structures.

What’s in this article?

• What are the legal implications of being incorporated vs. unincorporated?
  
• What are the different tax responsibilities for incorporated and unincorporated businesses?
  
• Liability and risk management in incorporated vs. unincorporated businesses
  
• How to choose the right business structure
  

What are the legal implications of being incorporated vs. unincorporated?

Incorporated and unincorporated businesses differ in how they handle liability, how they’re taxed, how they’re managed, how they can transfer ownership, and how they can raise capital. We’ll take a closer look below.

Liability

Liability is the primary legal distinction between incorporated and unincorporated businesses. In an unincorporated business (sole proprietorships and partnerships), the owner or owners are personally liable for the business’s debts and legal obligations. This means their personal assets – their house, car, savings – are at risk if the business faces financial difficulties or lawsuits.

In contrast, incorporated businesses (like corporations and LLCs) are considered separate legal entities from their owners and come with limited liability protection. This separation shields the owner’s personal assets from business liabilities so that if the business incurs debts or legal issues, only business assets are typically at stake.

Taxation

Taxation is another key difference between these business structures. Unincorporated businesses are pass-through entities, meaning business income is reported on the owner’s personal tax return. Incorporated businesses generally have more complex tax structures, and some are subject to double taxation, once at the corporate level and again on the owner’s dividends.

Management

Incorporated businesses generally need to adhere to more formalities, like holding regular meetings, keeping detailed records, and filing certain reports. Unincorporated businesses usually have fewer requirements.

Transferring ownership

Transferring ownership in an incorporated business is typically easier and more structured, often involving the sale of shares. In unincorporated businesses, ownership transfer can be more complex and might require dissolving the business and forming a new one.

Raising capital

Incorporated businesses, particularly corporations, have more options for raising capital through issuing stocks or bonds. Unincorporated businesses typically have fewer options for outside investment.

What are the different tax responsibilities for incorporated and unincorporated businesses?

Incorporated and unincorporated businesses have very different tax responsibilities. In addition to the differences outlined below, incorporated and unincorporated businesses can vary in the types of deductions and credits they’re permitted and the local tax rules they must follow. Business owners should always consult tax professionals if they have any questions about their tax responsibilities.

Here’s a breakdown of how taxation works for each business type.

Unincorporated businesses

• Pass-through taxation: Business profits and losses “pass through” to the owner’s individual tax return. The business itself doesn’t pay income tax.

• Self-employment tax: Owners are subjected to self-employment tax (Social Security and Medicare) on the business’s income.

• Personal income tax: Owners report business income on their personal income tax return and pay taxes at their individual income tax rate.

• Example: An unincorporated freelance writer would report their business income and expenses on Schedule C of their personal tax return and pay taxes at their individual income tax rate. They are also responsible for paying self-employment tax.

Incorporated businesses

• Separate tax entity: Corporations are considered separate tax entities from their owners and must file their own tax returns.

• Corporate income tax: Corporations pay income tax on their profits at the corporate tax rate.

• Double taxation: C corporations (C corps) are subject to double taxation. The corporation is taxed on its profits and shareholders pay personal income tax on dividends.

• Pass-through taxation: S corporations (S corps) and LLCs are pass-through entities, which avoid double taxation.

• Example: A large manufacturing C corp would file a corporate tax return and pay income tax on its profits at the corporate tax rate. Shareholders then pay personal income tax on dividends from the company.

Liability and risk management in incorporated vs. unincorporated businesses

Different business structures carry different levels of liability and risk for their owners. Here’s a quick rundown of how these factors vary by structure.

• Sole proprietorship: Sole proprietorships come with unlimited personal liability. The owner is personally responsible for all of the business’s debts and legal obligations and their personal assets are at risk if the business is sued or can’t pay its debts. This structure offers limited options for risk management: the owner can purchase liability insurance to help cover potential losses, but it might not fully protect personal assets.

• Partnership: In a partnership, each partner is subject to unlimited personal liability. Each partner is jointly and separately liable for the business’s debts and legal obligations. Options for managing risk are limited but include liability insurance and careful drafting of contracts. Partners can delineate how to share risks and responsibilities in a partnership agreement.

• Limited liability company (LLC): As the name suggests, LLCs come with limited liability. Owners (called members) are not personally liable for the business’s debts and obligations, and their personal assets are generally protected. LLCs offer stronger risk management options than unincorporated structures. LLCs can create operating agreements that outline risk management strategies, and liability insurance can provide additional protection.

• Corporation: Corporations also offer limited liability. Shareholders are not personally liable for the corporation’s debts and obligations. This business structure provides the strongest liability protection for owners, but in rare cases, courts might “pierce the corporate veil” and hold owners personally liable if they engage in fraudulent or illegal activities or fail to maintain corporate formalities. Some professions, like doctors and lawyers, can also face personal liability for professional negligence even if they operate within an incorporated structure. Corporations can manage risk in their company bylaws, internal controls, and with liability insurance.

How to choose the right business structure

Choosing the right business structure affects your day-to-day operations, legal liability to taxes, and ability to raise capital. Your personal work style, business goals, and risk tolerance are also important factors. Here’s a brief guide of what to consider when choosing how to structure your business.

Liability concerns

• Personal liability: Consider how much personal legal liability you can afford to take on. If your business involves substantial risks, a structure that offers limited liability (e.g., LLC, corporation) might be preferable to shield your personal assets.

• Industry risks: Certain industries are more prone to lawsuits or have higher debt risks, which can influence your choice of business structure. Manufacturing or construction, for instance, might benefit more from a corporation or LLC than a consulting firm.

Tax implications

• Tax flexibility: Sole proprietorships, partnerships, S corps, and LLCs offer pass-through taxation, avoiding double taxation. C corps are subject to double taxation.

• State tax considerations: Some states have favourable tax laws for certain types of businesses. Depending on where your business is based, this can also be a factor.

Funding needs

• Raising capital: Corporations are typically better suited to raising capital with the sale of equity in the form of stock. Investors might prefer corporations for their clear structure and potential return on investment through dividends and stock appreciation.

• Small business financing: If your funding needs are modest or you prefer to operate with loans or personal funds, simpler structures like sole proprietorships or partnerships might work best.

Operational flexibility and control

• Management structure: Corporations require a board of directors, regular meetings, and other formalities. If you prefer simplicity and direct control, an LLC or a sole proprietorship can be a good option.

• Decision-making processes: In a partnership, decisions are often made jointly, which can be a benefit or a hindrance depending on the dynamic between partners. LLCs offer management more flexibility, allowing members to structure their operations as they see fit.

Future planning

• Scalability: Corporations allow you to issue shares and attract investors. This can be advantageous if you have ambitious plans for growth.

• Exit strategies: It’s easier to transfer ownership through shares in a corporation than it is to transfer interest in a sole proprietorship. Consider how easy you want it to be to transfer ownership in the event of a sale.

Legal and administrative concerns

• Setup and maintenance: Corporations and LLCs require more paperwork and ongoing compliance than sole proprietorships or partnerships. Assess what level of administrative overhead you can manage.

• Professional advice: Consult a business attorney or financial advisor. They can provide expert advice based on your specific situation and goals.