What are the disadvantages of changing the company organization from sole proprietorship to a corporation?

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The advantages of changing from a sole proprietorship to corporation are the benefits that come from creating a separate legal entity for your business.3 min read

1. What Is a Sole Proprietorship?
2. What Are the Advantages and Disadvantages of a Sole Proprietorship?
3. What Is a Corporation?
4. What Are the Advantages and Disadvantages of a Corporation?
5. What Is an S Corporation?
6. What Are the Advantages and Disadvantages of an S Corporation?
7. What Is an LLC?

The advantages of changing from a sole proprietorship to corporation are the benefits that come from creating a separate legal entity for your business. While most businesses start out as sole proprietorships, many individuals find a corporate structure is more appropriate as the enterprise grows.

What Is a Sole Proprietorship?

More than 75 percent of businesses are sole proprietorships. This is an informal type of business run by one individual. It does not require state registration. The owner pays income taxes at the individual rate and is not responsible for corporate income taxes. The law considers a sole proprietorship to be the same as the individual. To establish a sole proprietorship, simply obtain the necessary certifications, business licenses, and tax ID number.

What Are the Advantages and Disadvantages of a Sole Proprietorship?

This type of business requires less paperwork and has fewer regulations to follow than other entities do. Other benefits of the sole proprietorship include:

• Full managerial control
• Full retention of profits
• No separate business tax return
• No required registration
• Easy creation and dissolution

Challenges for sole proprietors can include:

• Raising funds
• Attracting employees
• Inability to deduct personal costs such as medical insurance
• A higher tax burden than with other business entities

What Is a Corporation?

Corporations are considered a separate business entity by the state and can enjoy many of the same benefits and rights as an individual. They can have a name, enter contracts, and be taxed. Corporations are owned by shareholders, and a board of directors oversees major decisions and policies. When ownership changes, the corporation remains intact.

What Are the Advantages and Disadvantages of a Corporation?

Advantages of forming a corporation include:

• Limited liability for owners when it comes to business debts and financial obligations
• Separation of business and personal assets
• The ability to be owned by just one or more than one person
• The ability to issue stock and form a board of directors
• The ability to deduct the cost of employee benefits from the corporate income tax return
• Easy ownership transfer
• Perpetual succession

Disadvantages of forming a corporation include:

• Time-consuming and costly incorporation process
• Extensive regulations from local, state, and federal agencies
• Potentially higher tax burden because dividends are taxed at both the corporate and individual levels

What Is an S Corporation?

An S corporation election allows corporate shareholders to pass earnings and profits through to their individual income tax returns as dividends, thus avoiding corporate taxation. However, the shareholder must first be paid a reasonable compensation for his or her services. This amount varies based on occupation and geographic region but is generally the average salary you would have to pay someone else to do your job.

What Are the Advantages and Disadvantages of an S Corporation?

S corporations provide limited liability, pass-through taxation, and the ability to offset income from other sources with corporate losses. However, an S corporation is more expensive to form than a sole proprietorship or a partnership, requires more paperwork than a limited liability company (LLC), and requires income to be allocated based on ownership percentage. Only owners who have at least a 2 percent share can receive fringe benefits.

What Is an LLC?

An LLC is designed to combine the operational flexibility and tax benefits offered by a partnership as well as the limited liability of a corporation. Forming an LLC is more complicated than forming a partnership. The owners are called members and are typically named in the operating agreement. The LLC is formed for a specific duration, which can be extended before expiration by a vote of the members.

LLCs can have no more than two out of four corporate characteristics, including limited liability, centralized management, lifelong continuity, and free ownership transfer. LLC members can often avoid corporate taxes and have the flexibility to be taxed as either a corporation or a partnership.

LLCs are governed at the state level so laws, fees, and regulations vary by state. Corporations are the best choice if you want your business to exist in perpetuity or you want to sell shares to outside investors. When determining the best structure for your business, talk with a licensed attorney who can ensure you adhere to all federal and state tax laws.

If you need help with choosing a sole proprietorship or corporation for your business, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.

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Small companies in their early stages may operate as a sole proprietorship for many reasons. However, as a business grows, its needs change, and the owner may need enhanced protection for his personal assets from business obligations and liabilities as well as a better vehicle to attract investors. As a result, he may need to consider pursuing a more formal business organization, such as an LLC or a corporation.

Sole Proprietorship Defined

1. A sole proprietorship is a business owned by a single individual. It’s the simplest form of business organization, and requires no registration with the state to form. It is important to note you may need to register for a business license and/or operating permits, depending on the income-generating activity in which you participate. Any person who participates in an income-generating activity through his labor, and who is not directly employed by someone else, is a sole proprietor. Examples of sole proprietors are freelance positions and salespersons who only receive commissions as benefits.

Benefits

1. The main advantage gained by shifting from a sole proprietorship to a more formal organization type is liability protection. A sole proprietor is personally accountable for the debts and liabilities that his business generates. This means that his personal assets are in jeopardy if the business were to ever incur a large liability due to a lawsuit. However, business organizations such as Limited Liability Companies (LLCs) and corporations allow an individual to protect his personal assets from business liability using a corporate liability shield. Only the assets owned by the business are at risk to business liabilities in these organizations; the assets outside of the business generally cannot be claimed to settle business debts. Also, sole proprietors are, by definition, businesses with one owner. By becoming an LLC or corporation, you provide yourself with an easy way to bring a number of investors and partners into your business.

Disadvantage - State Filings

1. Unlike sole proprietorships, LLCs and corporations need to file documentation with the state in which they are headquartered before they can exist. In addition, most states require annual filings by these organizations to keep the Secretary of State aware of the business’s activities. Each filing often requires a small fee, and failure to file can cause the business to incur penalties or can even cause the state to revoke the enterprise’s ability to do business.

Disadvantages - Taxes

1. A sole proprietorship allows the owner to directly include all of his business income on his personal return without filing any additional documentation. LLCs and corporations have to file returns separate from their owners regarding annual income. A corporation even has to pay tax on the income it generates during the year, and then the IRS charges an additional levy on any corporate distributions to the taxpayer. The exception to the additional filing requirement is the single member LLC. If this type of LLC is taxed as a partnership, the owner can classify the LLC as a “disregarded entity” for tax purposes and record all of the business’s income on his personal tax return, as he would if he were a sole proprietor.

Considerations

1. If you decide to change to a more formal business organization type, contact a licensed attorney in your area to ensure that you meet all state and federal tax filing requirements. While every effort has been taken to ensure that this article’s completeness and accuracy, it is not intended to be legal advice.