Accounting

When Should You Consider Incorporating Your Small Business?

By Robyn Parets

When you first start a business, you don’t have to give too much thought to your legal structure, especially if you’re the boss and the only employee. For a team of one, being a Sole Proprietor makes sense. Still, at some point, you may want to change your sole proprietorship to a corporation or limited liability company (LLC).

Soon, you’ll have questions like these:

  • “Should I incorporate? If so, when?”
  • “Should I choose a corporation or an LLC?”
  • “Which business entity is best for my company?”

To help you decide whether you should incorporate or become an LLC, it’s important that you understand the advantages to both your current sole proprietorship as well as a corporate or LLC structure. Take a look.

What’s great about being a sole proprietor

A sole proprietorship essentially means that you and your business are one and the same entity. The truth is that more than 70 percent of U.S. businesses operate as sole proprietors, meaning there’s no legal distinction between the owner and the business. Many owners do very well with this model. This is often the route freelancers take because it requires no legal forms.

Here are some advantages to a sole proprietorship:

1. Simpler taxes

As a sole proprietor, you don’t have to file separate business taxes. However, you should still keep track of all of your business expenses and income as you’ll need to file this on a Schedule C along with your personal tax return. You can also use any business losses to offset other income on your tax return. For example, if you’re starting your business while still employed elsewhere, your business losses can help reduce the annual taxes you may need to pay.

2. Less paperwork

A sole proprietorship doesn’t require preparing separate financial statements for your business and other types of reports necessary for corporations.

3. You can keep all your profits

As the sole owner, you are entirely responsible for your business – the good and the bad. You’re the only one who will keep things afloat and running smoothly. You’re also the one who gets to keep your business profits.

Some advantages to a corporation or an LLC

Incorporating your company or forming a limited liability company makes your business a separate entity. There are different types of corporate entities for small businesses, including an S Corporation (also called “S-Corp”), a C Corporation (also called a “C-Corp”), and Limited Liability Corporations (also called an “LLC”).

The type of entity you choose will have implications for your financial future and taxes. Here’s a quick overview of the tax pros and cons of each:

1. S Corporation

This is a popular business structure for small businesses. Using this structure could help alleviate the steep income and self-employment taxes that sole proprietors pay. An S-Corp is a common structure among small businesses because individual owners pay taxes on their company’s earnings without paying separate business taxes on the entity’s net income, according to LegalZoom. Many consider and S-Corp a good option for businesses that plan to grow by taking on outside investors or going public.

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.

  1. LLC
    An LLC is perhaps the most popular structure for small businesses since it has fewer legal requirements and many of the same benefits as an S-Corp. 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.
  2. 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.

Considering the advantages

Let’s take a look at some of the advantages to these structures:

1. Protect your assets

This is a big one. If you’re concerned about your exposure to a lawsuit or debts, running your business as an LLC or Corporation is a good idea. With an S-Corp or LLC, your personal assets are shielded from lawsuits and bankruptcies.

For example, if someone slips and falls in your office and you’re a sole proprietor, you can be sued as your personal and business assets are rolled together. If your business is a corporation or LLC, however, a lawsuit would be filed against your business, so your personal assets aren’t on the line.

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, and so on. 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.

2. Credibility

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. Some consumers and vendors prefer to do business with a corporation or LLC rather than an individual. Having an “Inc.” or “LLC” after your company name can lend an air of legitimacy to your small business.

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.

3. Longevity

If you’re a sole proprietor and close your business or pass away, the company goes away too. If your business is a corporation or LLC, it can continue operating in your absence. If you plan to pass the business along to your children or a partner, an LLC or S-Corp may be the way to go.

4. Improve Your Chances of Securing a Business Loan

Another distinct, often-overlooked advantage of incorporating your small business is that lenders often require businesses to incorporate before they’ll lend them money. If you can’t get access to business financing at a crucial time, this may potentially limit your growth plans. Major banks often like to see that you maintain separate business and personal finances. Incorporating is a good way to do this.

Decisions, decisions

Although a sole proprietorship is the easiest structure because no documents are necessary, you leave yourself open to possible lawsuits and other financial liabilities. For this reason alone, it’s a wise idea to structure your business as an S-Corp or LLC, says Ian Engstrand, a partner at Goodwin Procter LLP in Boston.

“Both of these entities shield you from liability and they are both tax-efficient. Why not take advantage of this?” he says. “We’d rather business founders do it this way than dig into their pockets. This way, they can spend their money on other legal services down the line.”

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, so  you may want to enlist the help of an expert.

If you feel confident about taking on the task, Engstrand says that you can file the necessary corporation certificates or LLC formation documents yourself for free via any number of online sites, including Goodwin Procter’s Founders Workbench. The site shows you how to complete and file forms step by step.

To learn more about whether an S-Corp or LLC is the right structure for your business, it’s a good idea to consult with an attorney or tax advisor, says Engstrand.

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.

 

Disclaimer: Fundbox and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. Please consult a tax professional for information about tax laws and how they apply to your business.

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