Do I need to Incorporate My Small Business?

I think one of the biggest reasons to not incorporate a business is simplicity. It’s simpler to be a sole proprietor. A sole proprietorship has the least amount of paperwork and administration. Anyone can start a business as a sole proprietor at any time. Nothing must be filed with the government or the IRS. Bookkeeping for a sole proprietor is simple because you don’t need a balance sheet. Just an income statement, which is just a list of your income and expenses. Some of the things that make having a corporation more complicated include:

  • It can be expensive to register your business as corporation.
  • Bookkeeping is more complicated, you will need a balance sheet and income statement.
  • More tax returns. You will be responsible for the corporate return and your personal return.
  • If you decide to go out of business you will need to dissolve the corporation.
  • These things all add to your cost of doing business.

I will go over some of the advantages to incorporating and help you decide if they will benefit you.

Limited Liability

One of the main advantages to incorporating is the limited liability of the corporation. If you operate as a sole proprietorship, you assume all the liability of the business. This means your personal assets can be taken to pay the debts of the business. Assets like your house and car can be seized. When a business is incorporated, the owners are only liable for what they have invested in the company. The owner generally can’t have their house taken away to pay the company’s loans.

Limited liability sounds like a great thing, but most small businesses can’t take advantage of it. Let’s say you are trying to get a loan for your new small business. You go to the bank and apply for the loan and use the corporation’s name and tax ID number. When the banker looks at the corporation’s credit history, he won’t find a good credit score. The corporation hasn’t been in business long enough to have a good credit history. Then the banker is going to look at the assets of the corporation and see that it doesn’t have any assets. There is almost no chance the bank will give the corporation the loan. However, you have a good credit score and assets (house, car, mutual funds), so the banker says “I’ll give your corporation the loan, but you have to personally guarantee it.”

You need the loan for your business so you agree to personally guarantee it. Now you are on the hook for the debt. The bank can take your house and car to pay off the loan if the corporation doesn’t make the payments. No more limited liability. If you will need a bank loan to get your business started, limited liability may not be an advantage for you.


Raising Money

A bank may make you personally guarantee a loan, but corporations have other options. Corporations can raise money through equity financing by selling stock. You do not have to pay back equity financing generally and it doesn’t incur interest. The drawback is you give up some ownership in your business. If you are thinking about trying to raise money this way, then you need to incorporate. Angel investors and venture capitalists will probably require you to be incorporated. Most people who start a small business won’t be using venture capital so this won’t apply to them.

Corporations Are Perpetual

A corporation can continue to exist even if the owners die or get out of the business. A corporation can change owners and operators and stay in business, sole proprietorships can’t. It is much easier to sell a corporation than a sole proprietorship. Having your business as a corporation can also make estate planning easier. You can leave stock in the corporation to your children.

If you are starting a business as a side job for extra money you probably don’t need to worry about the business changing owners. An internet based business that sells a product only online, doesn’t need to worry about being sold. If you plan on accumulating assets in the corporation then you should think about being able to sell it. Otherwise it won’t matter if you are incorporated or not.

Credibility

Sometimes having “Inc”, “Ltd.”, or “Corp” in the company’s name can increase your credibility. People see that you are a corporation and they think you are more established than a sole proprietor. For contractor’s this could be a big advantage. Some companies may only want to do business with a corporation. When a company hires a contractor that is incorporated, they aren’t required to send a 1099 to the contractor. Not needing to keep track of 1099’s reduces accounting paperwork for a company. If you are thinking about starting an internet business as a re seller, or selling items for a commission, this won’t really help you. If you are a contractor that will be actively seeking customers to sell them a service, such as a painter or accountant, being a corporation will help you.

Name Registration

When you incorporate you are registering your business name with the state. This prevents anyone else from using your name in that state. A sole proprietorship or partnership does “own’ its name as far as the state is concerned. Anyone could take your name and use it. Someone could take your business name, incorporate it, and make you change your name. For someone who is trying to build a brand for their business, this could be a disaster. For someone working on commission it’s probably not that important.

Income Taxes

Income taxes are the area where incorporating can make the most difference. When your business is incorporated, you have more options for how your income is taxed. A sole proprietorship only has one option, Schedule C. When you are a sole proprietorship you pay income tax on all your net income from the business at your individual rate. You also pay Self-employment tax on all your net income from the business. The self-employment tax for 2017 is 15.3% on the first $127,200 in net self-employment income and 2.9% on any net self-employment income above $127,200.

A corporation pays the self-employment tax as a payroll tax and they only pay half of it. The employee pays the other half. If your business has a net income of $50,000 and you are a sole proprietor, you will pay $7,650 in self-employment tax. If your business is a corporation and has $50,000 in net income, you can avoid the self-employment tax by paying yourself a portion of the $50,000 as a salary. On a $25,000 salary the payroll tax (self-employment tax) would be $3,825. The other $25,000 only incurs income tax if you have an S-corporation.

You will pay self-employment tax if you make a net profit in your business. Being able to avoid paying this tax on some of your income will save you money. The more net income you have, the more you could possibly save. This savings will help you pay for the extra expense of being incorporated.

Every Situation is Different

This isn’t every possible scenario but it should be enough for you start thinking about your situation. You know what your circumstances are better than anyone else and you have to decide what is best for you. Gather as much knowledge as possible and talk to a CPA or attorney to help with your decision.


Nathan

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