From intellectual property to personal liability, incorporation protects against the biggest risks of entrepreneurship, but at a cost. For entrepreneurs struggling to break even, the timing of incorporation is everything. Incorporate too soon and you may pay fees long before your startup earns its first cent; wait too long and you risk losing your intended business name, your intellectual property, and even your assets. Detailed below are several considerations that you should keep in mind when determining your company's incorporation timeline, and why early incorporation is nearly always better.
The Earlier the Better
Early incorporation is advisable for most startups. Complications such as splitting among co-founders and handling questions of sweat equity are best dealt with officially, through incorporation. The following are just a few indications that the time to incorporate is now.
- Establishing a co-founder relationship – Co-founder issues regularly derail otherwise promising business ventures. Fellow founders may disagree on equity split and other issues. Early incorporation can reduce these qualms, ensuring that co-founders see eye to eye from the very beginning.
- Promising sweat equity – As a startup, you may lack the funds needed to pay your employees the rate they deserve; however, you have faith that, if they remain on board, they will be rewarded handsomely in the future. If you intend to reward your current employees or co-founders via sweat equity, it is imperative that you incorporate. Impressive promises of future shares are difficult to enforce without the ironclad guarantee of incorporation.
- Protecting intellectual property – Often referred to as the 'secret sauce' of business ownership, intellectual property sets your company and your competitors apart. Intellectual property is best protected through incorporation, particularly if you have founded your company with a business partner. If, after avoiding incorporation, your partner leaves, then you risk that person using your intellectual property for a competing venture. However, while early incorporation could prove valuable, many startups wait to incorporate until after they have registered intellectual property rights.
- Third-party funding – It is an exciting time when you have an early investor who can help get your company off the ground, but if you are not yet incorporated, you will not be able to take advantage of your investor's funds. However, corporation structure may matter more than timing.
- Anticipating acquisition – Not all entrepreneurs are in it for the long haul. Some launch businesses with the express desire to eventually be acquired by a larger corporation. This approach is particularly common among today's app developers, many of whom wish to enjoy the benefits of long-term capital gains taxation and avoid the high taxes ascribed to ordinary income. Unfortunately, this is not possible until the company's founder has held stock for at least one year. In other words, early incorporation is essential. Ideally, founders aiming for eventual acquisition should incorporate before the app is even developed, for example, and definitely before the app is ready for beta testing. This will ensure quick turnaround, allowing for successful acquisition while the app remains relevant.
- Protecting personal liability – For many entrepreneurs, the chief argument in favor of incorporation is personal liability. If your startup encounters significant challenges, incorporation will allow you to rest easy, knowing that your personal property remains safe. If you avoid incorporation, your assets—including your savings, real estate, even your vehicle—could be at risk in the event of a lawsuit. As a sole proprietor, you are personally liable for all debt and any business-related activity.
Incorporating before the Startup's Launch
For some entrepreneurs, early incorporation is not good enough. Many startups begin the process long before their business commences operation. There are definite merits to this approach: by highlighting expectations and obligations right away, founders can avoid the types of problems that famously plagued Facebook and other co-founded startups. Pre-formation incorporation is ideal if you have a clear vision of your company's future; you are currently making plans with co-founders, employees, investors, and other parties; you believe your intellectual property may be otherwise at risk; and you can realistically handle the cost of incorporation in addition to other expenses.
When to Hold off on Incorporation
Most companies benefit from incorporating as early as possible, but there are always exceptions, most of which involve sole proprietors who do not intend to expand their business. The following signs may indicate that it is best to hold off on incorporation.
- Casual business ownership – Minor businesses that primarily serve as side hustles may not require incorporation, which could potentially constitute a frivolous expense. If you primarily regard your business as a hobby, you may gain little from the hassle of incorporation. This is especially true if you are in it for yourself and have no intention of drafting a job offer letter in the near future.
- Piercing the corporate veil – A seemingly sinister term, piercing the corporate veil occurs when courts hold shareholders personally liable for a corporation's actions. This is particularly common when, despite being incorporated, a business is not actually run like a true corporation. Casual business owners who fail to follow established protocol or local regulations risk losing their assets, despite having gone through the effort to incorporate. If you in any way doubt your ability to run your sole proprietorship as a corporation, then incorporating is not right for you at this time.
- Financial considerations – When it comes down to it, most people who decide not to incorporate immediately (or ever) cite financial concerns. Although incorporation can deliver numerous financial benefits, it may come with a steep upfront price tag plus ongoing maintenance costs. Mistakes or missed deadlines may elicit more severe consequences following incorporation; a Forbes opinion piece cites numerous instances of entrepreneurs facing well over $10,000 in IRS interest and penalties due to late filing. Although late filing is also problematic for sole proprietors, the sheer volume of necessary records make missed deadlines far more likely for incorporated entrepreneurs.
- Severe risk of going under – If the future of your business is uncertain due to severe financial issues, the money you dedicate to incorporation is probably best spent improving your operations. After all, advance planning for your share in your startup will provide little solace if your company is at immediate risk of going under. Ultimately, you will need to weigh the cost of incorporation against the risks you could face if you do not incorporate. If you face any risk of adverse legal action with clients or creditors, incorporation could be well worth the cost.
Reassessing the Timing of Incorporation
Incorporation may not presently be the best option for your business. That does not necessarily mean, however, that it will always be a bad idea. As your venture evolves, take stock of your situation and whether it merits incorporation and the accompanying legal documents. The following signs may indicate that it is finally time to incorporate.
- Your profits exceed $100,000 – If you have transitioned from a "don't quit your day job" line of thinking to full-on entrepreneurship then it may be time to incorporate, especially if your shifted priorities have resulted in greater profits. Forbes contributor Cameron Keng recommends incorporating as soon as your net business income reaches $100,000. At this point, proper tax planning can drastically reduce your tax liability, but only if your business is incorporated.
- You are ready to hire an employee – As a sole proprietor you only have yourself to worry about, and perhaps you disregard the personal liability risks of not incorporating. This all changes the moment you hire an employee or develop an independent contractor agreement for a long-term contract. Now you must consider the future liability of not only yourself, but also your future employees. Ideally, you will complete the articles of incorporation before you draw up an employment contract or employee confidentiality agreement.
- You want to take out a loan – You may take little interest in investor activity, but even taking out a loan can be difficult if you lack incorporation. You may have been able to get by loan-free in the early days of your startup, but if you later determine that you need to borrow money for business purposes, you will find it far easier to do so if you seek incorporation first. As an incorporated entity, you no longer need to rely on your personal credit.
- Concerns from customers and manufacturers – Manufacturers, distributors, and even customers are well aware of the risks of avoiding incorporation. If you fail to incorporate your business, they may sense recklessness on your part. If your refusal to incorporate begins to harm your relationships with manufacturers and other parties, it may be time to reconsider.
The Best Day to Incorporate: January 1st
Whether you have chosen to incorporate early or hold off, timing will continue to play a significant role when you finally pursue incorporation. For many entrepreneurs, one day alone is ideal: January 1st. If you incorporate on any other day, you risk dealing with multiple tax returns due to your separate periods as a sole proprietor and as an incorporated business owner.
Unfortunately, the incorporation process takes far longer than one day. Once you have submitted the necessary documents, you can expect to wait between one and two months before you make your S or C corporation or LLC official. During that time, you will suffer the ill tax effects of sole proprietorship plus the prospect of a second tax return. Thankfully, there is a round-about way to take advantage of that desirable January 1st incorporation date: delayed filing.
How Does Delayed Filing Work?
With delayed filing, you can draft your company's articles of incorporation and other necessary paperwork ahead of time, but delay the actual date of incorporation to January 1st. Any date of delay is possible with this approach, but most entrepreneurs favor the first day of the year. This approach is best if you begin to consider incorporation around October or November, as you can promptly complete necessary legal forms and then wait for January incorporation. If, however, you express interest in February or March for incorporation, then the tax expenses associated with remaining a sole proprietor may be of greater concern than the inconvenience of filing multiple returns. Delayed filing is ultimately most beneficial for businesses not yet in operation or eager to avoid extra paperwork.
The Value of Pre-Incorporation Agreements
If you remain unsure as to the ideal timing for incorporation but feel that the process will ultimately provide valuable business security, you could benefit from a pre-incorporation agreement. Pre-incorporation contracts outline basic business decisions, such as your entity's name and where it will ultimately be incorporated. These legal documents ensure that the issue of incorporation remains at the forefront. Without such a contract, it becomes easy to fall into a holding pattern and continue to procrastinate until it is too late. Furthermore, a pre-incorporation legal contract could ultimately hasten the incorporation process.
No matter your stance on incorporation, it is important you at least consider it early on. Delays are common, so the sooner you make a decision, the sooner you can develop an accurate vision of your company's future, with or without incorporation. Ultimately, timing will depend on how serious you are about your business; the involvement of co-founders, employers, or investors; and your company's tax situation.
LegalNature can help you with all aspects of the incorporation process. Click here to create your company's articles of incorporation today.
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