Incorporation can bring businesses a range of advantages in the marketplace. From legal protections to increased credibility with stakeholders, the decision to incorporate can help businesses evolve at any stage—especially if they want to grow and gain access to financial benefits.

The shift from unincorporated to incorporated can protect businesses’ personal assets while also offering opportunities for growth, scalability, and potential tax benefits. Below, we’ll discuss how incorporating can help businesses.

What’s in this article?

• What does it mean to incorporate a business?
  
• Do you have to incorporate your business?
  
• Advantages of incorporating
  

What does it mean to incorporate a business?

Incorporating a business means transitioning from a sole proprietorship or partnership into a corporation, a legal entity distinct from its owners. This process requires formal documentation, which is typically filed with a state’s Secretary of State or equivalent governing body.

• Legal entity formation: When a business incorporates, it becomes its own legal entity. From a legal standpoint, the corporation is separate from the people who own or run it. This distinction has implications for liability, taxes, and operations.

• Documentation and registration: The process requires that a business file articles of incorporation. This document includes foundational details, such as the corporation’s name, address, and information about shares of stock.

• Ownership structure: Corporations issue shares of stock, which represent ownership in the company. These shares can be distributed among a small group of individuals or, in the case of public corporations, traded on stock exchanges.

• Governance and operations: Corporations are managed by a board of directors and must adhere to certain governance protocols. They often have officers such as a CEO, CFO, and COO, who handle the day-to-day operations.

• Regulations and compliance: As a separate legal entity, corporations must comply with specific laws and regulations at local, state, and federal levels. This often involves annual reporting, fee payments, and other administrative responsibilities.

• Taxation considerations: Corporations face distinct taxation rules. Depending on the jurisdiction and type of corporation, they may be subject to double taxation, where both the corporation’s income and dividends paid to shareholders are taxed. However, they also might have access to tax advantages not available to unincorporated entities.

Do you have to incorporate your business?

No, you don’t have to incorporate your business. Incorporation is a choice, one that depends on the needs and goals of the specific business. Many businesses operate successfully as sole proprietorships or partnerships without ever incorporating. But there are a number of advantages that are available only to incorporated businesses, which we’ll discuss below.

Advantages of incorporating

From taxes to growth trajectory to recruiting top talent, incorporating offers businesses several benefits. Here’s an explanation of the advantages that motivate businesses to incorporate:

Liability

The concept of personal liability is an important consideration for anyone starting a business. For unincorporated businesses, such as sole proprietorships and partnerships, the distinction between the business entity and its owner or owners is blurred. This lack of separation means that any legal or financial challenges that the business faces can affect the personal domain of its owner or partners.

For instance, imagine that a customer sues an unincorporated business for damages. Whether the reason behind the suit is a product defect, an operational oversight, or a contractual disagreement, the financial implications can be substantial. Without the protective barrier of incorporation, the owner’s personal savings, property, and other assets can become targets for restitution. Similarly, if the business incurs significant debt it cannot repay, creditors may pursue the owner’s personal assets as a means of recovery.

The situation would be very different if the company that the customer was suing was an incorporated entity. The process of incorporation creates a distinct legal entity, separate from its founders, shareholders, or directors. This separation acts as a protective barrier, sometimes called the “corporate veil.” When legal or financial issues arise, the assets of this separate entity are on the line. The personal belongings and assets of shareholders and directors remain insulated from such challenges.

However, this shield isn’t absolute. Cases of fraud or certain types of negligence can “pierce the corporate veil,” when individuals behind the corporation can be held personally liable. But even with this caveat, incorporation offers a level of protection that unincorporated structures cannot match. For many business leaders, this reduced risk of personal exposure is a compelling incentive to incorporate.

Tax benefits

Taxation is typically one of the biggest considerations for businesses when evaluating operational structures. The differences between the tax treatments of incorporated and unincorporated businesses can be significant.

Corporations are recognized as separate legal entities and are subject to distinct tax obligations. This differentiation provides them access to several potential benefits. One notable advantage is the potential for lower tax rates. Depending on jurisdiction and specific conditions, corporate income tax rates can be more favorable than individual income tax rates, leading to substantial savings—especially for businesses with high revenue.

Another significant benefit for corporations is the ability to carry forward losses. If a corporation incurs a loss in a given year, it can use this loss to offset profits in subsequent years. This feature can be particularly advantageous for startups or businesses experiencing a challenging period, allowing them to mitigate the tax impact of more prosperous years with the losses from less favorable ones.

Deductions present another area where corporations may have an advantage. While all businesses have access to a range of deductions, corporations often have access to a broader set or more substantial deductions. These deductions span business areas from employee benefits to operational costs and can considerably reduce a corporation’s taxable income.

Owners of sole proprietorships or partnerships, on the other hand, typically blend their business and personal finances for tax purposes. Profits or losses from the business flow through directly to the owner’s or partners’ personal income tax returns. While this structure is simple, it doesn’t afford the same breadth of tax strategies available to corporations.

Additionally, corporations can sometimes receive specific tax credits that are out of reach for unincorporated entities. These credits, which directly reduce the tax owed, can cover a range of activities, from research and development to environmental initiatives.

In order to use these tax advantages, corporations face more rigorous reporting requirements and must be diligent in their record-keeping. But when used effectively, the potential tax benefits can far outweigh the administrative overhead.

Permanence and transferability

One of the often-overlooked advantages of incorporation is the concept of perpetuity. When you establish a corporation, your business has the potential to outlive its founders and original shareholders. This continuity offers stability that might be harder to achieve with other business structures.

A corporation has the ability to transfer ownership without disrupting day-to-day operations. For example, if a thriving business with hundreds of employees and active contracts is a corporation and its owner decides to retire or pursue other ventures, the owner can simply sell their shares to another party. The transition might be noticeable at the shareholder level, but for employees, customers, and partners, nothing changes.

By contrast, in sole proprietorships and partnerships, ownership changes often require renegotiating contracts, re-establishing relationships, and sometimes even restructuring the business model. For long-standing customers or clients, this can lead to uncertainty and potentially jeopardize relationships that took years to build.

Additionally, the process of selling shares in a corporation is well-established and recognized globally. There are many stock exchanges, brokers, and regulatory frameworks designed to facilitate this. When dealing with sole proprietorships or partnerships, transferring ownership often means bespoke agreements, which can be time-consuming and costly.

Perpetuity and ease of ownership transfer are two major reasons why investors prefer dealing with corporations. Corporations offer a clear exit strategy, which is especially attractive for venture capitalists and angel investors who anticipate a return on their investment through the sale of their shares at a future date.

Credibility and growth

Incorporating a business can help bolster its reputation and credibility in the eyes of stakeholders. The process of incorporation signals to the external market that a business is committed to long-term growth and has undertaken the necessary formalities to solidify its presence in the industry.

From a customer’s perspective, a corporation might have a higher level of reliability compared to an unincorporated entity. For instance, corporations undergo more rigorous reporting processes, which could make them more accountable for their products or services.

Suppliers, too, may prefer working with corporations on long-term contracts or collaborations. Because of corporations’ formal structures, they have less flexibility and are therefore less likely to experience abrupt changes. This can lead to more favorable terms or more willingness to negotiate agreements.

Investors often choose corporations when considering where to allocate their funds. This is because the act of incorporating demonstrates a commitment to growth and sustainability, and corporations offer clearer mechanisms for shareholder rights and protections, which can make the investment seem less risky.

For businesses with ambitious growth plans, such as those seeking substantial external investments or considering an initial public offering (IPO), incorporation is often a non-negotiable requirement. External investors or capital markets demand the transparency, governance structures, and shareholder protections that come with a corporate status.

Access to capital

Corporations have structural advantages that put them in a strong position when seeking capital. One of these advantages is the ability to issue shares of stock. When a corporation sells shares, it offers pieces of ownership in the business to investors. These investors, motivated by the prospect of dividends or appreciation in share value, provide the corporation with the needed capital.

Another avenue open to corporations is the issuance of bonds. Unlike shares, which offer a piece of ownership, bonds are essentially loans from investors to the corporation. The company commits to paying back the principal amount of the bond after a set period, along with periodic interest payments. This mechanism offers corporations a method to raise substantial funds without diluting company ownership.

These fundraising avenues are significant. With more capital at their disposal, corporations can invest more heavily in research and development, pursue ambitious projects, acquire other businesses, or expand into new markets. Such actions can propel the corporation forward, creating more value for shareholders and positioning the entity for long-term growth.

Ownership transfer

The structure of a corporation offers an advantage when it comes to the transfer of ownership. Having shares that represent ownership means that these can be sold or transferred with relative ease, making the entire process more transparent and manageable. This contrasts sharply with the challenges that sole proprietorships and partnerships face when attempting to execute a similar change.

Shares, by design, are modular units of ownership. When someone wants to buy into a corporation, they can purchase a certain number of these shares, effectively acquiring a proportional stake in the company. From a significant stake to a fractional interest, shares can accommodate different levels of investments without the need to renegotiate the company’s foundational documents or restructure its underlying operations.

Sole proprietorships and partnerships don’t have this modular system in place. Transferring ownership often means diving deep into agreements, assets, liabilities, and, potentially, the renegotiation of contractual obligations. This can be a complex, drawn-out process.

Additionally, the share-based system in corporations is supported by a robust legal framework. There are clear rules about how shares can be sold, what rights they confer, and how disputes related to them are resolved. This clarity is often absent in the less formalized structures of sole proprietorships and partnerships, where disputes can become mired in ambiguity.

Moreover, the liquidity associated with corporate shares, especially in publicly traded companies, is appealing. Investors can buy or sell shares quickly on stock exchanges, providing owners with a level of liquidity that’s hard to match in other business structures.

Separate credit rating

Corporations have the ability to establish and build a credit rating separate from those of their owners. Their distinct financial identity serves multiple purposes and can offer an advantage, especially in scenarios that require financial borrowing or establishing credit relationships.

This separation means that the financial behaviors and credit histories of the individual owners do not directly impact the corporation’s creditworthiness. For example, if an owner has made financial missteps in the past or has debts on their personal record, these will not be a limiting factor when the corporation seeks to secure funding. The corporation’s creditworthiness is determined by its own financial behavior, including its payment history, debt load, and financial management.

A strong corporate credit rating can lead to more favorable financing terms. Often, lenders offer better interest rates and terms to entities with solid credit histories. A corporation with a good credit rating might find it easier to secure larger loans or more favorable interest rates than an individual or an unincorporated business entity. Over time, these favorable terms can result in substantial savings and financial benefits for the corporation.

Additionally, having a separate credit rating can provide an added layer of protection for the owners. If the corporation encounters financial challenges or fails to repay a loan, the personal credit ratings of the owners remain shielded, as long as corporate formalities are maintained and there’s no personal guarantee involved. This clear delineation between personal and corporate finances can give owners peace of mind and encourage more calculated risk-taking, which can be beneficial for business growth.

Maintaining a distinct corporate credit rating can also benefit relationships with vendors and suppliers. Since many suppliers evaluate the creditworthiness of a corporation before offering terms or establishing long-term contracts, a strong corporate credit rating can lead to better terms, such as longer payment periods or discounts, which can improve operational efficiency and profitability.

Employee benefits

Corporations can offer benefits such as stock options, which can serve as a compelling incentive for prospective and current employees. This capability plays a significant role in the recruitment and retention strategies of many businesses, especially when competing for top-tier talent in competitive industries.

Stock options grant employees the right to purchase a specific number of shares of the company’s stock at a predetermined price. When the value of the company’s stock rises above this predetermined price, employees can sell their shares and realize a profit. This mechanism aligns the interests of the employees with the overall performance of the company. As the company performs well, both shareholders and employees with stock options stand to benefit. For potential hires, especially those at senior levels or with specialized skills, stock options can tip the balance when choosing between job offers.

Stock options can also play an important role in employee retention. The typical vesting schedule attached to stock options means that employees must remain with the company for a certain period before they can fully benefit from their options. This creates an incentive for long-term commitment and reduces the likelihood of turnover. Reducing turnover leads to lower recruitment costs, and stronger institutional knowledge and team cohesion.