Many small business owners first launch their businesses as sole proprietorships. It happens naturally – you just start selling a product or offering a service and that’s the legal default. But your business structure can have significant implications, and continuing as a sole proprietorship comes with some very serious risks – and not many benefits.
There are a number of options for corporate structure. A sole proprietorship is the simplest and is the legal default. You don’t have to register or file anything (although you can if you want to). Your profits are taxed as personal income and you’re personally liable for the business. You can also operate as a partnership, if there are multiple owners. That also gets taxed as your personal income and you’re personally liable.
You also have the option to “incorporate.” That sounds a little technical and complicated, but it’s actually pretty simple. There are two types of corporations, the traditional “C” corporations and “S” corporations (“S” Corp). Both forms of incorporation limit your personal legal liability as the business owner. In an S corp, the profits are taxed as your personal income, but only the business is liable for its operations and debts. As a C corp, the corporation is a separate legal entity and is subject to the corporate tax. As with an S corp, only the company has liability.
It’s a little bit more complicated to create a corporation than it is to simply work as a sole proprietor, but it’s worth it. Here’s why.
1. Protecting Your Assets
One of the main reasons most small business owners chose to incorporate is the issue of business liability. As we touched on above, all corporations are considered separate entities for legal purposes. This means that corporation owners will not be held personally responsible for the financial obligations of the corporation. Likewise, owners of a corporation are not held personally liable in the event of a lawsuit against the corporation.
What does this mean in plain English? In short, it means that a corporation’s owners’ personal assets and property are protected from lawsuits, judgments, or liens. In the eyes of the law, the corporation and the corporate owner are deemed two separate entities.
Ultimately, if your incorporated business loses a lawsuit, your personals assets — such as your bank accounts, savings, even your home or cars — won’t be on the line. The same corporate protection rule also applies to any outstanding corporate debt. Even if your corporation declares bankruptcy, your personal assets still won’t be at risk. Many business owners find that this “corporate shield” is reason enough to incorporate.
One caveat to note: To ensure full corporate protection, the company must adhere to corporate structure and follow all relevant corporate law. Otherwise, there may be a dispute about “piercing the corporate veil” and attaching the owners’ assets. The state in which you choose to incorporate will have detailed guidance about what it takes to be recognized as a corporation.
A second reason many small businesses choose to incorporate is to benefit from the added credibility of being an official corporation. Those three letter letters, Inc.., can greatly boost your business legitimacy with customers, vendors, even potential lenders. Incorporation indicates that you are a legitimate business to the eyes of the world.
Incorporating your business can even help you secure a business loan. Banks may be more likely to grant funding to an established corporate entity than to a generic small business. When you incorporate, you’ll be able to open up business accounts and borrow money in the name of the corporation.
Aside from banking, you may also find it easier to secure funding and investors when you are a corporation. Your investors can become shareholders rather than lenders, which may be more attractive. And some lenders and investors will require it.
A third primary reason that small business owners incorporate is because of the tax benefits of incorporation. The legal structure of your business will impact the amount of taxes you pay; for better or for worse. To clarify how different business structure will impact your tax liability, check with your tax professionals, because this area is always evolving.
In basic terms, a traditional C corporation is taxed in a kind of complicated way. The corporation has to pay tax on its profits. As an owner, you’ll also have to pay taxes on any dividends your corporation pays and on your salary from the business.
S Corps are taxed differently – the income from an S corp is considered the personal income of the owner and is taxed at your personal rate.
Some say that corporations are less likely to be audited by the IRS than sole proprietorships. The logic behind this is that sole proprietorships may accidentally overestimate their business expenses.
Corporate taxation is inherently complex, so consulting with a tax expert can help explain the pros and cons of all business structures and taxes. Additionally, a tax expert can perform a thorough business evaluation, as well as ensure you’re complying with all relevant tax laws.
Get The Inc.
Many small businesses start as sole proprietorships but incorporate early on to avoid the liability issues – that’s the most common reason. But as we explained, incorporation has a number of other benefits as well. All it takes is filling out a couple of simple forms online and your business will become its own separate entity. Talk to your attorney and accountant about whether an S corp or a C corp is the best option for you – as soon as possible.
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