An article on the legal resource webpage Nolo.com suggests that independent contractors should consider incorporating (founding a legal corporation) in order to get more clients. It argues that clients would prefer to hire corporations over independent contractors because it reduces the likelihood of lawsuits and IRS audits.
The reasons for this are a little complicated. But it helps to think about things from a client's perspective. Clients want to avoid any potential risks when hiring temporary workers. When clients hire a corporate entity instead of a contractor, they know they won't have to face any employment lawsuits or audits.
What Does Incorporation Mean for Small IT Businesses?
Before we go into how incorporating can improve your business relationships, let's talk about what incorporation is.
When you own an unincorporated business by yourself, you are called a sole proprietor. There is no legal distinction between you and your business. Incorporating provides you with that legal distinction, which offers you a couple important benefits:
- You cannot be sued as an individual. If you're sued in an Errors and Omissions lawsuit, it's the business that will face the ramifications of the lawsuit – not you or your employees. If you weren’t incorporated, you could be held personally responsible for business liabilities. So if your business didn’t have the money to foot a legal bill, your personal bank account would be on the line.
- Your business is responsible for paying back loans. If you take out a business loan, your business is responsible for paying back that loan. Once again, your personal funds are distinct from your business funds, even if you are your corporation’s only employee.
In other words, incorporation offers you more protection because your business is a legally recognized organization. In fact, there are different types of corporations and business entities that offer various types of protection and have different tax responsibilities. Always consult with a lawyer to determine whether, when, and how you should incorporate.
Generally speaking, it's good for your business to incorporate, but you might have to pay additional corporate taxes and legal fees, which might not be worth it for some smaller operations.
To learn more about the timing for incorporation, see the Small Business Administration's guide to incorporating your business.
Why Incorporating Your Tech Businesses Eases Client Worries
The main reason why incorporating may help you get more work is that it can ease some of the worries your clients \ have regarding independent contractors. Clients can be sued or face penalties for "misclassifying" independent contractors. Misclassification occurs when a business hires someone as a contractor who, for all intents and purposes, should actually be treated like an employee.
Misclassification can come up during employment lawsuits or IRS audits. In these situations the judge or auditor uses a philosophy that resembles the duck test: "If looks like a duck, quacks like a duck, and walks like a duck, then it's a duck."
When a judge looks at an employment dispute, he determines whether or not the company (your client) treats the hired party (you) like an employee. For example, a judge might look to see if the company…
- Supervises the contractor’s work.
- Has a long-term engagement with the contractor.
- Expects the contractor to follow its employee standards.
If the company-contractor relationship ticks these boxes, judges rule that the contractor should be classified as an employee, and the client will owe back taxes and some unpaid benefits to the contractor.
Hiring an IT consultant who has incorporated her business means clients don't have to worry about this.
Case Study for Incorporation: Improve Business Relationships
Let’s look at incorporation from a client's perspective. Say you're hired as an IT project manager. When you work with a client, the client actually hires the corporation (not you) to perform the work. Even if you are the sole employee of your corporation, it is a distinct entity from yourself.
As an employee of your corporation, you will of course do the work, but it's your corporation's responsibility to make sure that you are covered by appropriate Workers' Comp Insurance, paid fairly, and receive proper benefits. The client can't be held liable for these things. And that’s why many clients prefer corporations over sole proprietors.
How Incorporation Can Help You
To summarize, incorporation offers many benefits to small IT companies:
- It shields you from being held personally responsible in Errors and Omissions lawsuits.
- It eases clients’ concerns because they know they can't be sued for employment disputes or audited by the IRS regarding your employment.
- It helps you compete with IT staffing agencies, which are able to offer the same comfort to clients.
As we mentioned above, always consult with a lawyer if you’re considering incorporation. For small-business owners, the decision to incorporate is a financial one. You have to weigh the benefits of more security and potential new clients against the additional tax liabilities and legal costs.
For more risk management tips, browse the TechInsurance Small Business Center blog.