If you are running your business as a sole proprietorship, perhaps you are thinking about incorporating. This is a major decision and you should give it serious consideration.
There are advantages and disadvantages to forming a corporation. Here’s an overview.
Advantages.
1. Tax savings. There are numerous tax deductions and other tax reduction strategies available to a corporation that are not available to the sole proprietorship. For example, if a sole proprietor can only deduct health insurance premiums to the extent of his/her business profit. So if you have a loss on Schedule C, you don’t get to deduct your premiums and it is lost forever. If you have a small profit, but your profit is less than your insurance cost, the excess of premium over profit is also a lost deduction. A C corporation can deduct medical insurance regardless of the bottom line.
Another example would be the potential self-employment tax savings of an S corporation. In a sole proprietorship, all profit is subject to SE tax (up to the government established limit). In an S corporation, only the wages paid to the shareholder/employee would be subject to payroll taxes (the equivalent of SE tax); any profit reported on Schedule K-1 legally avoids payroll tax.
2. Limited liability. Generally speaking, a sole proprietor has unlimited liability. An insurance policy can certainly provide protection up to the policy limits, but after that, it is possible that a lawsuit against the business would have to be satisfied by utilizing the owner’s personal assets. A corporation provides limited liability, which means that the owner’s are liable only to the extent of their investment in the corporation. Generally speaking, personal assets are not available to satisfy the claims against the business.
Disadvantages.
1. Paperwork. You must file articles of incorporation with your state to form the corporation, and prepare other documents such as bylaws. You must hold regular meeting of the directors and shareholders, and document those meetings with minutes and other major decisions with corporate resolutions. All this paperwork is commonly known as “corporate formalities.” If you’re a corporation, you must look like one and act like one, otherwise you run the risk of losing your corporate status.
2. More paperwork. A corporation must file its own separate income tax return. And if you’ve never done payroll before as a sole proprietor (because you had no employees), as a corporation you will be required to pay yourself as an employee of the corporation and issue real paychecks and climb the small mountain of paperwork that accompanies a paycheck (payroll taxes, payroll tax payments, and payroll tax returns, along with year-end W-2’s).
3. Cost. If you love paperwork, you can save hundreds if not thousands of dollars if you spend many hours learning how to do the paperwork mentioned above. And if you happen to have a legal and/or tax and/or accounting background, perhaps that would be fine. But it is more likely that you’ll need to outsource these tasks, and that will mean additional expense for professional services.
One final comment: Do some research. Consult with a professional. Get some help. To make a wise decision regarding incorporating, you’ll probably need it.
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