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Some of you may have considered incorporating your business because you have heard that it brings several tax and financial advantages. If your business is very small or very new, those theoretical advantages may be elusive.
Most advantages of incorporating are outgrowths of an incorporated business being a separate legal entity. In theory, this gives the corporation the advantages of unlimited life, easy transfer of ownership, and limited liability for investors. These in turn are supposed to result in the real advantages of easier access to financing, better credit ratings, and greater growth potential. But these real advantages do not always come to very small corporations.
Some of these really come from large size, proven performance, and a history of previous investors’ successes with the company. Being corporations is not the reason for their advantages and successes. Most descriptions of advantages of incorporating do not list the exceptions that apply to most very small businesses.
Unlimited life applies to small corporate businesses in legal terms, but this cannot provide a guarantee of business continuation after the death or retirement of its leader and principal stockholder. Usually the entrepreneur who established the business holds most stock in a very small corporation. Leaving the business to heirs in this situation is a function of estate planning rather than incorporation. Estate taxes are the challenge in passing the company stock to heirs.
For many very small businesses the current $675,000 federal estate-tax exemption keeps the inheritance from being a problem, and that exemption will grow under the current law–although it’s unclear what will happen after 2010. But, even if you value your business at less than that exemption today, you certainly are working to increase its value. Will you remember to make time to adjust your estate plan when the value passes that threshold? Will you be constantly revaluing the business to even know when it does? The top tax rate on inheritance is due to fall to 45 percent, but that is still a big bite for your heirs to deal with. Proper estate planning is the tool to deal with small-business continuity, not incorporation. Estate planning will handle passing on a sole proprietorship as well.
Easy transfer of ownership is based on the corporation’s stock being easy to sell to other investors. But selling the stock requires willing buyers. And willing buyers are few for corporations that have diminished prospects for unlimited life or limited liability. Investors want to buy stock in companies that will continue to exist and that do not expose them to financial losses beyond their investment. The other, and perhaps primary, factor that makes selling a small business difficult is that only 40 percent survive for six years, whether incorporated or not.
Limited liability applies to a corporation’s financial situation only if its assets are adequate to cover loans. Creditors require personal guarantees if corporate assets are too small. A personal guarantee means that the owners must put up their personal assets to cover the loans. This eliminates the limited liability for the owners. If even the personal assets of the primary owners are inadequate, the lender may require additional guarantors to cosign and put their personal assets on the line for the business. Even the SBA requires principal owners to give up limited liability in a small corporation.
Other points to consider: An advantage to incorporating is that it limits personal liability in situations involving actions of employees, such as vehicle accidents. Incorporation improves this type of liability for owners, but adequate insurance may reduce the exposure just as well.
One perceived disadvantage of incorporating that may not apply to small businesses is the requirement to disclose details about the business. Large, publicly-held corporations must make wholesale disclosures of financial and operational details, but small, closely-held corporations do not have to, although they have some disclosure requirements such as those of the Department of Labor.
If you are considering incorporating, first talk with your accountant and lawyer. Use the points made in this article to ask the right questions of those advisors before deciding–-make sure that the advantages of incorporation are worth the costs.
For any advice about starting a business, expanding or improving any aspect of your business, or solving any business problem, contact SCORE South Metro Chapter 628. The counselors of SCORE South Metro Chapter are experienced business owners and managers who volunteer their experience and knowledge to help small business owners and potential small business owners achieve success.
Client service is the objective of the SCORE South Metro Chapter and our business counselors are dedicated to providing the best possible service. Face-to-face, online, or through workshops, the counselors of SCORE South Metro Chapter are able and willing to aid in the success of small business. SCORE counselors provide you with in-depth, industry-specific business assistance to help evaluate a business idea or plan stimulate business growth and ensure long-term stability.
SCORE South Metro can be reached in person at 101 W. Burnsville Pkwy, Suite # 152, Burnsville, MN 55337; by telephone at 952-890-7020; by Fax at 952-890-7019; by email southmetro@scoreminn.org or through our website www.score-southmetro.org
Author John Eakins, is a member and counselor of SCORE Rochester, Chapter 406. Many of his articles have been published in the Southeast Business Journal (SBJ), Rochester, Minnesota. It is his hope and ours that you find the information beneficial
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