Are you a sole proprietor who’s been thinking about forming a corporation? Here are four great reasons to do so.
1. Liability protection.
When you operate your business as a sole proprietorship, your personal assets are at risk. Should something unfortunate happen and you are the defendant in a business-related lawsuit, personally owned assets can be used to satisfy the claims of others against you. Generally speaking, if your business is a corporation, you are only liable to the extent of your ownership interest in the corporation.
2. Avoid double taxation of corporate profits.
You get the benefit of liability protection whether you form a C corporation or an S Corporation. So which type of corporation is better? Several factors come into play when determining the answer to that question, but one benefit of the S Corporation is that you avoid the C Corporation’s double taxation of corporate profits. C Corporation profit is taxed twice – once to the corporation and a second time to the individual shareholders. The S Corporation profit is only taxed once – to the individual shareholders on their personal income tax returns.
3. Reduce self-employment tax.
As a sole proprietor, your profits are subject to both income tax and the dreaded self-employment tax. When you form an S Corporation, your profits are still subject to income tax, but profits legally avoid the self-employment tax. If you are working as an employee of the corporation, you will incur payroll tax on that compensation (which is the equivalent of self-employment tax), but paying yourself reasonable compensation may result in a lower overall tax liability, and the tax savings can be significant.
4. Reduce the likelihood of an IRS audit.
It’s a known fact that sole proprietors are audited at a higher rate than corporations. Owning a sole proprietorship means filing a Schedule C; and filing a Schedule C is like putting a big bulls-eye on your personal income tax return. Forming a corporation removes the Schedule C from your personal tax returns, because a corporation files its own separate income tax return.
Keep in mind that the S Corporation isn’t necessarily the best entity choice for all small business owners. For many sole proprietors, it is the best entity. But several other factors come into play, such as the nature of the business, what kind of products or services it provides, and whether real estate is owned by the business. So do not make a decision based only on the four benefits described above. With the help of a competent tax professional, you should do a thorough analysis of all the advantages and disadvantages of forming an S Corporation.