Should you incorporate your small business?

An important question you should ask yourself as a small business owner is: should I incorporate my business?  

A common scenario is for small businesses to start out as sole proprietorships or partnerships and become incorporated at some later date when the business has grown. A sole proprietorship is a one-person business that is not registered with the state as a corporation.  Sole proprietorships are so easy to set up and maintain that you may already own one without knowing it.  “For instance, if you are a freelance photographer or writer, a craftsperson who takes jobs on a contract basis, a salesperson who receives only commissions, or an independent contractor who isn't on an employer's regular payroll, you are automatically a sole proprietor.”  The drawback of sole proprietorship is that the business owner assumes all the liability of the company.  When a business becomes incorporated, an individual shareholder’s liability is limited to the amount he or she has invested in the company.  If you’re a sole proprietor, your personal assets can be seized to pay the debts of your business.  Unlike an LLC or corporation, you generally don’t have to file any specific forms or pay any fees to start up a sole proprietorship.  One of the advantages of doing business as a sole proprietor is that you can avoid a “double tax.”  Whereas corporations pay income tax separately from their owners, as a sole proprietor, all your business income is treated as your personal income.  Additionally, there are no restrictions on the number of people you can hire, and from the tax and legal perspective there is no distinction between you and your business. You can therefore hire as many people as you want and also recruit independent contractors if need be.

However, there are many advantages to incorporating your business.  Most importantly, as mentioned above: limited liability.  An additional advantage of incorporating is continuance.  “Unlike a sole proprietorship, a corporation has an unlimited life span; the corporation will continue to exist even if the shareholders die or leave the business, or if the ownership of the business changes.”  It is also easier for corporations to raise money than sole proprietors as they can sell shares and raise equity capital.  As a sole proprietor, you get your income when it is received but as a corporation, you have the ability to determine when you receive that income which can be a tax advantage.  Another tax advantage of being incorporated is: tax deferral.  As a corporation, you can defer paying some taxes until a later time which could be a benefit if the tax rates fall.  Most significantly with regard to taxes, “if you incorporate your small business, your corporation may qualify for the small business deduction. This annual tax credit is calculated at the rate of 16% on the first $200,000 of taxable income, which may be a much lower tax rate than that applied to your personal income.”  Experts say the number one benefit of incorporating your business is credibility.  Some investors see corporations as more stable than sole proprietorships and are more willing to do business with them as a result.

Of course, there are also disadvantages to incorporating your business as well.  The number one problem for a small business owner?  It’s expensive.  It also takes longer to set up than a sole proprietorship as it is a far more complex legal structure.  The fees charged for incorporating a business, either federally or locally, can be as high as several hundred dollars. When setting up a corporation, you will need to file paperwork with your state’s office that charters corporations, which is time-consuming as well. You also must pay annual fees.  Additionally, as I mentioned earlier, a corporation must pay a “double tax” as you have two tax returns on file – a corporation tax and an income tax.  There are also extra legal formalities and paperwork – detailed accounting/auditing books and meeting notes, for example.

As I’ve discussed in today’s blog, there are both advantages and disadvantages to incorporating your business.  While it has its benefits, it can be an arduous, expensive process.  I suggest giving it some serious thought and doing thorough research before leaving the world of sole proprietorship.  If you do choose to go ahead and incorporate, you can check out: https://www.legalzoom.com/ where you can form an LLC in 3-easy steps or go to: http://www.usa.gov/Business/Incorporate.shtml to find out the steps to getting your business incorporated in your own state.

Until next time…