Do I Really Need To Incorporate in Pennsylvania?

At some point in his or her career, nearly every sole proprietor and most every small business partner will ask, and perhaps agonize over the question, “Do I really need to incorporate?” Some businesses proceed to incorporate with little more reason than the desire to bolster a trade name with the suffix “Inc.” or “LLC.” (Throughout this article, we will use the term “incorporate” to mean both the formation of a corporate and the organization of other limited liability companies, such as LLCs.) Others who may desperately require additional liability protection or organization proceed without it, unaware of the need to incorporate. What follows is a discussion of some of the factors which small businesses should consider in deciding whether or not to incorporate.

Size

In the equation of incorporation, as elsewhere, size really does matter. Tax professionals routinely look at business volume, both in absolute numbers and in percentage increases in growth, as a key factor in determining whether a business should incorporate. From a legal perspective, the greater the number of business owners or partners, and the greater the differentiation in their rights and responsibilities in the business, the greater the need to incorporate in order to define the varying interests of each owner, to establish smooth mechanisms for the transfer of shares (i.e., stock and membership interests) and to set appropriate restrictions on ownership transfer (i.e., buy-sell agreements). Incorporation and the consequent transferability of shares can provide a business with a ready mechanism for the business or other shareholders to buy out an owner’s shares and still maintain business continuity when that owner retires or passes away.

The Nature of Potential Liabilities

Many small businesses incorporate with the singular goal of protecting their individual shareholders from the potential future liabilities of the business. However, the level of protection afforded by incorporation varies widely from one business to the next. For some businesses, incorporation is not necessary. For others, it is necessary but hardly sufficient. In determining whether a small business can obtain a significant additional measure of liability protection from incorporation, one must consider the nature of the potential liabilities of the business. For many businesses, tort liabilities (personal injury, professional liability, products liability and the like) present the greatest risk of claims with the potential for exceeding the available assets of the business. For businesses with these risks, liability insurance policies with adequate policy limits are always the best line of defense. For these businesses, incorporation is best viewed as an additional measure of liability protection against the potential that a catastrophic loss might exceed the available insurance policy limits, and thus expose shareholders to individual liability.

For other businesses, the cumulative effect of multiple contract liabilities (real estate and equipment acquisitions, operating loans, contractor liabilities and the like) pose the greater risk. Because a business generally cannot insure against pure contract liabilities, incorporation is often the only means of limiting a business owner’s personal liability for contract liabilities. Unfortunately, there is a catch. Just as few lenders will extend credit to a recent high school graduate without the co-signature of his parents, many creditors are likewise unwilling to contract with a fledgling corporation or LLC without the individual co-signatures of its shareholders and, often, their spouses. In effect, this customary practice of requiring individual co-signatures wipes out limited liability protection as to any creditor who requires co-signature. So at least until the corporation or LLC establishes its own track record, the understandably conservative business practices of its creditors will often diminish the limited liability protections afforded by incorporation.

Vulnerability of Separate Assets

Whether incorporation is strictly necessary or all but irrelevant depends not only on the nature of a company’s potential liabilities, but also upon the manner in which assets are titled. Take, for example, a small proprietor whose non-business assets are owned entirely by herself and her husband as tenants by the entireties—the form of marital ownership under Pennsylvania law. If the husband is not actively involved as an owner or manager of the wife’s business, there is already a large measure of built-in liability protection because, under Pennsylvania law, entireties property is generally beyond the legal reach of creditors who have claims against one spouse but not the other. For the same reason, however, traditional “mom and pop” businesses, owned by both husband and wife, bear an inherent risk of non-business assets being placed on the executioner’s block even if the business is incorporated. That is, if a corporation’s business debt is deemed a marital obligation, and if the corporation is grossly under-capitalized and therefore unable to pay a particular debt, the creditor may be able to “pierce the corporate veil” and execute on marital assets to satisfy the corporation’s liability to the creditor. In this situation, and in many others, incorporation may not be enough. The business must also be properly capitalized or properly insured, or both and satisfy all corporate formalities, to have a full measure of limited liability protection.

Payroll Taxes, Workers’ Compensation Premiums, etc.

One fundamental difference between operating as a corporation or LLC and operating as a sole proprietorship or partnership is that business owners become employees of their businesses as soon as they incorporate. In this regard, as with many of life’s decisions, incorporation is a mixed bag.

Many sole proprietors and partners view the prospect of “going on payroll” as a joyous deliverance from the bondage of quarterly estimated tax payments. Others focus on the requirement that the owner-cum-employee be placed on workers’ compensation insurance coverage. For businesses already providing comp coverage for other employees, the benefit of placing the owner on existing comp coverage will usually outweigh the costs. Sole proprietors without other employees may assume that they themselves will never fall victim to a work-related injury, and may therefore view the cost and red tape associated with purchasing workers’ compensation insurance as a waste of both money and time.

Income Taxes

As a general rule, when a small business owner seeks out the limited liability protections of incorporation, he does not wish to be taxed as a corporation. The income of traditional Subchapter C corporations is taxed once at the corporate level, with deductions for employee compensation, and taxed again at the shareholder level, and is also subject to higher corporate net income tax rates. Nevertheless, income taxation is rarely a significant issue in the decision of whether to incorporate a small business. Corporations and small businesses alike can elect taxation under Subchapter S of the Internal Revenue Code, and LLCs can elect to be treated as “disregarded entities” for income tax purposes. In either case, the corporation or LLC maintains limited liability protection while being taxed as if it were still a sole proprietorship or partnership — one of those rare instances in which the law allows us to eat our cake and have it too.

For a more detailed discussion of the tax ramifications of incorporation, contact the lawyers at Wolf, Baldwin & Associates, P.C. for an initial consultation today. We will be able to help you weigh the costs and benefits of incorporation in light of your particular business circumstances.

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