Entity choice is one of the first decisions that you have to make when starting your business. Two common entity choices are sole proprietorships and corporations. You can change it later, but changing can cost time and money. Though forming and running a sole proprietorship is generally easier than incorporation, incorporation does offer a number of other advantages.
When you operate as a sole proprietor, you and your business share the same identity. If you take out money, its the same as your business taking out money. When your business promises to deliver products, you're personally responsible. If your company can't pay its debts, the creditors can come after you. When you incorporate, your business takes on a legal existence separate from you, which means the business can act for itself such as owning property in the business name, entering contracts for itself, and suing or being sued.
Your entity choice also affects your income taxes. The IRS defines a sole proprietor as someone who "owns an unincorporated business by himself or herself." When you work as a sole proprietor, you report the business income on Schedule C, which then gets included on your personal tax return. You also have to pay self-employment taxes on the income. When you incorporate, the corporation "is recognized as a separate taxpaying entity," which means the corporation must file its own tax return and pay the corporate income tax. Any distributions the corporation makes to you as the owner is then taxed a second time as a dividend on your personal income tax return.
When you're a sole proprietor, if your company gets sued, you could end up footing the bill because you have unlimited liability. For example, if the plaintiff wins a $500,000 judgment because she slipped and fell in your store, if the business doesn't have the money to pay, your personal assets could be on the line. Conversely, when you incorporate, you now have limited liability, which means you can generally only lose the money that you put into the company.
When you operate as a sole proprietor, you are the business so when you die, the business generally goes with you because there isn't a separate entity to pass on to your heirs. When you incorporate, the business attains a perpetual existence that lasts indefinitely, even though you die. In addition, since the company can own its own property, you can leave your ownership interest in the company to your heirs rather than trying to keep all of the business property together.
Transfer of Ownership
Transferring ownership in a corporation is much easier than transferring part of a sole proprietorship. A corporation issues ownership shares, which can easily be sold to others. This differences becomes very significant when you want to bring on additional investors. For example, if your business is ready to expand, but you don't have the free cash, you might want to sell a portion of your company to an outside investor. Additionally, if you want to leave a portion of your business to each of your children when you die, you can leave each of them a specified number of shares.