Updated: Nov 1, 2021
Many people say that business owners will save thousands of dollars after they incorporate. You could save from incorporating, but you should not rush into this important step in the life of your business.
The legal form under which you set up your business can have a significant impact on:
The way you run your operation
The costs of running your operation
How you are taxed
It is critical to understand the business structure options available to you and when each is most appropriate for your business. Owner liability and income taxation are two main factors that determine which business structure to choose. The most common forms of business are sole proprietorship, C corporation, S corporation and limited liability company (LLC).
Because each business structure comes with different tax consequences, you will want to make your selection wisely and choose the structure that most closely matches your business's needs. Contact a business service provider, such as ATBS, to discuss your needs to help you choose the best option for your business.
Below is a list of the most popular business structures:
The simplest structure is the sole proprietorship, which usually involves just one individual who owns and operates the enterprise. If you intend to work alone, this structure may be the way to go.
The tax aspects of a sole proprietorship are pleasing because the expenses and your income from the business are included on your personal income tax return. Your profits and losses are recorded on a form called Schedule C, which is filed with your 1040. This can be desirable because any business losses you suffer may offset the income you have earned from your other sources.
Some of the disadvantages of operating as a sole proprietor are that you need to calculate how much self-employment tax you owe. You pay both employee and employer portions of employment taxes on your self-employed income, which can add up to a large amount depending on your net profit.
Selecting the sole proprietorship business structure means you are personally responsible for your company's liabilities. As a result, you are placing your assets at risk, and they could be seized to satisfy a business debt or a legal claim filed against you.
In addition to paying annual self-employment taxes, you must make estimated tax payments if you expect to owe at least $1,000 in federal taxes for the year after deducting your withholding and credits, and your withholding will be less than the smaller of: 1) 90 percent of the tax to be shown on your current year tax return or 2) 100 percent of your previous year's tax liability. The federal government permits you to pay estimated taxes in four equal amounts throughout the year on the 15th of April, June, September and January. Some advantages of the sole proprietorship are that your business earnings are taxed only once, unlike other business structures. The employer portion of the self-employed tax paid is deductible above the line, which reduces your taxable income. Also, health insurance costs for you, your spouse, and dependents can be deducted up to your net self-employment income as an above the line deduction.
The corporate structure is more complex and expensive to set up than most other business structures. A corporation is an independent legal entity, separate from its owners, and requires complying with more regulations and tax requirements.
The biggest benefit for a business owner who decides to incorporate is the liability protection he or she receives. A corporation's debt is not considered that of its owners, so if you organize your business as a corporation, you are not putting your personal assets at risk. A corporation also can retain some of its profits without the owner paying tax on them. A C Corporation does have some negative aspects. C Corporations are formed under the laws of each state with its own set of regulations and must follow more complex rules and regulations than a sole proprietorship. Another downside to forming a corporation is the owners of the corporation pay a double tax on the business's earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual tax rates on their personal income tax returns.
A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. However, the IRS has limits on what it believes to be reasonable compensation.
The S corporation is more attractive to small-business owners than a C corporation. That's because an S corporation has some appealing tax benefits and still provides business owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there's just one level of federal tax to pay.
S corporations do come with some disadvantages. S corporations are subject to many of the same rules corporations follow, which also involve higher legal and tax service costs. They also must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions.
The legal and accounting costs of setting up an S corporation are also similar to those for a C corporation. A corporation is not required to pay tax on earnings paid as reasonable compensation, and it can deduct the payments as a business expense. However, the IRS has limits on what it considers to be reasonable.
To become an S Corporation and be treated as one for income tax purposes, the shareholders need to make an election with the federal government to be taxed as an S Corporation, which is an election that is frequently missed. By not filing the S election, you will be taxed as a C Corporation and subject to double taxation rules.
Limited Liability Company (LLC’s)
Limited Liability Companies have become one of the more popular structures in recent years especially with entrepreneurs.
LLC’s were created to provide business owners with the liability protection that corporations benefit from without the double taxation. Earnings and losses pass through to the owners and are included on their personal tax returns. If there is only one member in the LLC it is considered a disregarded entity and is taxed the same way as a sole-proprietorship unless you elect to be taxed as an S Corporation.
To set up an LLC, you must file articles of organization with the secretary of state in the state where you intend to do business. Some states also require you to file an operating agreement, which is comparable to a partnership agreement.
Even after you settle on a business structure, remember that the conditions that make one type of business structure favorable are always subject to changes in the laws. It makes sense to re-examine your form of business from time to time to make sure you are using the one that provides the most benefit to you, which your ATBS Business Consultant can assist you with.
To learn more about incorporating your business make sure you download our FREE ebook on Owner-Operator Incorporation.