Is incorporating your business the right move? This guide will help you decide by walking you through the pros and cons of small business incorporation.
You run a business that you’re proud of. But at some point, you start wondering if you should make things a little more official. Soon enough, your thoughts turn to small business incorporation.
Is incorporating right for your business? This guide will walk you through the pros and cons, different business structures to consider, and how to begin the process of incorporating your small business.
What Does Small Business Incorporation Mean?
When most people start a business, they begin as a sole proprietor. This is the most common business structure because it’s the default structure: If you don’t register as a different kind of business, you will automatically be a sole proprietor.
While a sole proprietorship may fit your business for a while, it might not be a long-term solution. The government doesn’t consider a sole proprietorship to be a separate business entity from the business owner. As a result, you’re missing out on benefits by keeping personal and business mixed.
If being a sole proprietor isn’t right for you, it’s time to incorporate. Incorporation is the process of formally filing your business as a separate entity with your state.
Why Small Business Incorporation?
There are a number of reasons it’s beneficial to incorporate your small business, including:
- Limited liability protection: As a sole proprietor, you and your business are one and the same. This means that you could be held personally liable for business debts and need to repay them from your personal assets. Incorporating creates a separate business entity, which can protect your personal assets.
- Tax optimization: Business taxes can get complicated and expensive quickly. But you may be able to minimize or optimize the taxes that you pay by choosing the right business structure.
- Credibility: Having a business that is registered with the state can make you look more credible to potential customers.
- Access to funding: Sole proprietors don’t have access to business funding opportunities because they’re not a separate business entity. For example, as a sole proprietor, you can’t sell shares in your company to raise money and banks may be less willing to give you a business loan.
- Unlimited life: When the owner of a sole proprietorship passes away, the business ends. Incorporation can keep your business running for generations.
What Are Some Drawbacks to Small Business Incorporation?
While incorporating a small business is a good idea, there are also drawbacks to doing so, including:
- Additional paperwork and tax filings: Once you incorporate, you will have a long list of administrative tasks that you need to do regularly for your business. This can include additional tax filings, record-keeping and tax deadlines that are different from your personal tax deadline. Initially, you may feel as though you are constantly filing taxes and organizing paperwork.
- Increased cost: Many states require annual filing fees, and depending on the state these fees can be very expensive. Depending on your business structure you may also decide to pay for a payroll service, as well as hire a lawyer or a certified public accountant (CPA) to ensure everything is set up and reported correctly.
- Double taxation: While some business formations can be tax advantageous, a C corporation can come with the very expensive downside of double taxation. The IRS can tax a corporation twice: Once on its corporate profits and again on the shareholder business tax return.
Small Business Incorporation: Business Structure Options
If you want to run an incorporated business rather than a sole proprietorship, you have a number of options to choose from.
If there are two or more owners in your business, you are eligible to incorporate as a partnership. A partnership can either be a limited partnership (LP) or a limited liability partnership (LLP).
Under an LP, you’ll have one general partner and the other partners will be limited partners. The general partner doesn’t get the benefit of liability protection—they will be held personally liable for business debts just like a sole proprietor would. Limited partners will have personal liability protection, but they may have less control than the general partner.
With an LLP, all partners have personal liability protection.
Limited Liability Company (LLC)
An LLC is a company structure that allows you personal liability protection from business debts. Unlike a partnership, you can form an LLC with just one owner. An LLC is easier to run operationally than a C corporation and has the flexibility of choosing how it wants to be taxed.
This is the most complex of all the business structures, but it offers the strongest personal liability protection to its owners. Corporations can raise money by selling stock to shareholders. Because a C corporation is the most complex—and most expensive to maintain—this is usually the business structure option for companies most concerned with liability, or for those that expect to raise capital.
An S corporation is a C corporation that has met certain criteria and has filed with the IRS to be considered as such. To qualify as an S corporation, the business must have fewer than 100 shareholders and all must be U.S. citizens.
While an S corporation has to maintain the strict operational and filing requirements of a C corporation, they offer better tax advantages.
How Is an Incorporated Business Taxed?
Before we jump into how incorporated businesses are taxed, it’s important to understand how you’ll be taxed if you don’t incorporate. As a sole proprietor, you’ll report all of your business income on Schedule C of your personal tax return. Aside from paying income tax on what you earn, you’ll also need to pay self-employment tax, which is 15.3%.
Once you incorporate, that may change how you report and pay taxes on your business income.
A partnership is a pass-through entity. This means that the partnership itself isn’t taxed. The profits earned by the partnership are passed through and reported on each partner’s individual tax return.
Each year a partnership must file Form 1065 with the IRS. This is an information return that includes income and expenses for the year. The partnership then provides each partner with a Schedule K-1, which shows the partner their share of the profits.
A C corporation is considered a separate business entity and files its own tax returns. Therefore, as a C corporation owner, you’ll need to file both a personal tax return and a business tax return, Form 1120.
Let’s say you own a small digital media agency and formed a C corporation for it. Your corporation will first be taxed on its profits in its corporate tax return. Then, if you want to take that money home, you’ll need to distribute it to yourself (or any other shareholders) in the form of a dividend. These dividends will be taxed on your personal tax return at the qualifying dividend rate. This is what’s known as double taxation, and it can be pretty hefty for the small business owner.
Small businesses often opt for S corporation status in order to avoid double taxation. An S corporation files Form 1120 S at tax time but doesn’t pay its own taxes. Rather, company profits are passed through and reported on the personal income tax return of the shareholders.
S corporation owners are taxed on the company profits based on the percentage of shares they own (e.g., if you own 50% of an S corporation, you’ll be taxed on 50% of the profits).
If you elect S corporation status for your corporation, your business itself will pay no income tax. If you work in the business, you need to pay yourself a reasonable wage for your job. These wages are then subject to your personal income tax rate. When you distribute the rest of the profits to yourself as a dividend, these will be taxed at the qualifying dividend rate.
LLCs have flexibility and for the most part, can choose how they are taxed. If there is only one member (owner) in the LLC, the IRS treats them as a sole proprietor for tax purposes. However, they still receive the liability protection.
When there is more than one member in an LLC, the IRS allows the LLC to be taxed as a corporation or a partnership, depending on what the LLC members choose.
For example, you can choose to structure your LLC as a single-member disregarded entity and it will be taxed like a sole proprietorship. Alternatively, you can structure your LLC to be taxed like a C corporation or S corporation.
There will be additional tax requirements for whatever state you incorporate in—this post covers the federal requirements. Be sure to check with your state to understand what you need to file for each business structure and by when.
When Should You Consider Small Business Incorporation?
While it’s much easier to run a business as a sole proprietor, incorporating can be worth the hassle and additional expense. Some reasons you’ll want to consider incorporating include:
This may be one of the reasons that businesses incorporate right away—owners want to protect their personal assets from the start.
As a sole proprietor, you are always going to have to pay self-employment taxes on all of your self-employment income. As you grow and earn more money, incorporating as an LLC or S corporation may help you save some money in self-employment taxes.
If you’re starting a business with another person (or multiple people), or you’re bringing someone into the business after you’ve started, your only option is to incorporate.
If you’re hoping to bring on investors to your business, you’ll want to incorporate. Since a sole proprietorship isn’t a separate business, investors may be hesitant to invest.
Can You Incorporate If You’re a One-Person Business?
If you are a one person business, you can use any business structure to incorporate other than a partnership. To incorporate as a partnership, you’ll need to have two or more business owners.
Where Should You Incorporate?
At some point, when deciding whether to incorporate you may be told that it’s best to incorporate in whichever state is the cheapest. But that may not work out well for many small business owners.
Let’s say you register your business in Nevada because there are no state corporate income or franchise taxes. But, you live and work out of your home in California. To continue to do business in California, you’ll need to register as a foreign business entity there too. Your business is incorporated in Nevada but is also registered to do business in California.
This subjects you to many of the state fees and taxes in California; for example, you’ll need to pay state income taxes for any income collected there. But you’ll still also have to pay any of your annual fees in Nevada too.
Often it’s best for small business owners to incorporate in the state they live in. If you’re considering incorporating in a different state, a CPA can help you decide what’s right for you.
How Do You Incorporate Your Small Business?
If you’ve decided to incorporate, there are a few ways you can do this. You can take the do-it-yourself route, use an online service or hire a lawyer.
The do-it-yourself route is going to be your least expensive option, but it will probably take you the most time. You’ll want to check with your state to understand its filing requirements.
Once you formally incorporate with your state, the IRS may have additional requirements. For example, if you’ve decided to incorporate as an S corporation, you’ll also need to file form 2553 with the IRS.
Using an online service to help you navigate the process will be more expensive, but it may save you some time.
Hiring a lawyer to help you incorporate your business is going to be the most expensive option, and in most cases is unnecessary. If you want to get advice specific to your situation, have a complex ownership situation or hope to raise capital quickly, hiring a lawyer is likely worth the cost.
This post was updated in March 2020.
about the author
Erica Gellerman is a CPA, MBA, content marketing writer, and founder of The Worth Project. Her work has been featured on Forbes, Money, Business Insider, The Everygirl, and more. She currently lives in Hawaii.