Americans are gearing up for Tax Day, April 15, next month. But there's a more imminent deadline to worry about—March 17, the deadline for corporate tax returns. That's a date that unfortunately will pass without notice by many of the country's small-business people—despite the wealth of evidence about the benefits of incorporation even for small companies.
As Scott Shane, an economics professor at Case Western Reserve University, discusses in his recent book The Illusions of Entrepreneurship the most recent data show that only about half of self-employed people in the U.S. workforce run incorporated businesses.
But Shane argues that entrepreneurs who fail to incorporate are making a huge mistake. Corporations have a much higher rate of success than sole proprietorships, he writes, even when it comes to small businesses. He says that the academic literature shows that incorporated small businesses outperform unincorporated in terms of profitability, employment growth, sales growth, and other measures.Yet could it be that businesses that bother to incorporate just have their act together already and are destined for greater success? Shane admits that such a self-selection phenomenon is possible. On the other hand, he counters, "it could be that there are many things that you can't do well unless you're incorporated."
The biggest positive effect of incorporation is on legal liability. If you get sued as a sole proprietor, your personal assets are on the line. But a corporation is liable only for the assets put into the corporation. This protection can be a boon for a business's growth. "In some cases it's harder to grow large because the risk to you is too great," Shane says.
Of course, some small-business owners may think, for instance, that their little home business, maybe run out of a basement office, isn't significant enough to raise such worries. Indeed, Shane admits that getting incorporated may not make sense for "tiny little businesses" because "if you have very little money to put into the business, you don't have a lot of risk, so it may not be worth the complexity."
But Deborah Sweeney, incorporation expert for the software company Intuit, argues that "even the smallest eBay business has a risk of being sued." If you're shipping a product around the country or world, for instance, and it gets lost, you can run into legal problems.
For some small-business owners, the risks become too great to ignore. Bill Goodwin, a recent graduate of the University of Southern California, has barely got his business off the ground early in 2008, but he has already filed to make it a limited liability corporation, or LLC. Goodwin is launching Visual Politics, a website and consulting service that uses digital technology to map political activity for municipalities and other clients. Though his website is not up yet, he has received one major contract, and that was enough to persuade him he needed to incorporate. "Once you hit a certain threshold of activity, the likelihood of things going wrong or someone suing you—at that point it's not worth it for me to be doing business with my whole livelihood on the line," Goodwin says.
So why do so many entrepreneurs and small-business owners choose to be sole proprietors rather than incorporate? The biggest reason is just convenience. "The default option is sole proprietorships," Shane notes. Many people are intimidated by the legal hoops they would have to jump through to get incorporated, not to mention the prospect of a more complicated tax filing season. But the Internet has greatly simplified the process of incorporating. Lawyers traditionally helped businesses through the incorporation process, often to the tune of $2,000 to $4,000. Now, you can go online and get incorporated for just a few hundred dollars. After being shocked by what his lawyer wanted to charge, Goodwin says, he went to legalzoom.com and found it not only far cheaper but way more convenient. "It took 15 minutes to get the ball rolling" and $680 to turn his business into an LLC, he says, using the most expensive and fastest option.