Many small business owners, especially freelancers and consultants, go into business without a clear plan for how to legally structure it. Even businesses who’ve been operational for some time might be wondering if now is the time to incorporate.
But should you and what structure should you choose?
It’s confusing territory and there isn’t a one-size-fits-all answer. The truth is that more than 70% of U.S. businesses operate as sole proprietors, meaning there’s no legal distinction between the owner and the business. And many do very well with this model.
But what advantages (and disadvantages) does incorporation really offer? And should your business consider incorporation?
Here’s a summary of the main advantages and disadvantages of incorporation, plus some signs that it might be time to consider incorporating your small business, or not!
The Tax Advantages (and Disadvantages) of Incorporating your Small Business
Many new business owners start considering incorporation because of the perceived tax benefits. For some, this may be true, but not all.
- S Corporation – This is a popular business structure for small businesses, and could help alleviate the steep income and self-employment taxes that sole proprietors pay. As a guideline, if you make between $80,000 – $100,000 in bottom line profit then structuring your freelance business as an S-Corporation might be worth considering. Check out this quick video from CPAs, Blumer & Associates, for a simple explanation of the math behind the tax benefits of forming an S-Corporation.
- LLC – LLCs don’t actually gain much in tax savings over and above a sole proprietor. This is because, like a sole proprietorship, the business owner is taxed on their entire net income.
- C Corporation – The tax deduction benefits of being a C Corporation are significant, especially for employers who can claim a 100% deduction of employee health insurance costs as well as other deduction benefits such as group term life insurance, business-provided vehicles, certain education costs, and more. Corporate tax rates are also lower than the individual tax rates of sole proprietors or LLC owners. Read more about the pros and cons (and there are some big cons that are worth talking to a tax expert about) in C corporations: Benefits are a big (deductible) benefit.
Incorporate to Protect Your Personal Assets
If you’re concerned about your exposure to a lawsuit or debts, running your business as an LLC or Corporation is a good idea.
For example, if a client sues you or you find yourself pursued by creditors for outstanding debt, as an incorporated business only your business assets are at risk, your home, savings, etc. are safe. Furthermore, if you’re concerned that your business liability insurance (if you have any) won’t protect your personal assets against claims, then forming an LLC can help.
Build Credibility for Your Business
Structuring your business as an LLC or other corporate structure can lend credibility to your business because it sends the message that you’re serious about what you do.
That being said, incorporation isn’t the only way that a small business can establish credibility. Oftentimes, simply using a trade name or “doing business as” (DBA) name, instead of your own name can add credibility to your operations and marketing efforts. You’ll need to check the availability of the name you choose with your local government and then register your DBA name accordingly.
Improve Your Chances of Securing a Business Loan by Incorporating
Another distinct, and often overlooked advantage of incorporating your small business, is that lenders often require businesses to incorporate before they’ll lend them money – which may potentially limit your growth plans. Banks like to see that your business and personal finances are separated; incorporating is a good way to do this.
How to Incorporate Your Small Business
The process of incorporating your business varies by state. Becoming an LLC can be done fairly simply via your state website. Alternatively you can work with a business lawyer or use an online service such as LegalZoom or BizFilings. Forming an S Corporation or a C Corporation gets more complex and is best done with the help of an expert.
The Bottom Line
Incorporating your small business is a big decision and may benefit your business substantially or it may have no impact at all. If you’re unsure, always consult a lawyer or tax professional. These folks can build a picture of your unique business needs and help you come to a decision that makes good fiscal and business sense.