If you’re like most small-business owners, you probably started your operation as either a sole proprietorship or, if you had co-owners, a partnership. This company structure is the simplest and least costly to set up, with less paperwork required.
However, sole proprietorships and partnerships are not separate legal entities from their owners. You report your share of the company’s earnings on your personal income taxes, and you are legally responsible for the business’s debts and liabilities. So, perhaps you’ve been advised to incorporate in order to claim tax benefits and to protect yourself from personal liability for the company’s operations?
Proceed with caution. It’s true that incorporation can provide some of these benefits, but only in certain situations. Incorporating your business too early may end up costing you more in taxes — and fail to provide you with any liability protection. Here are some factors to consider.
In general, federal and state corporate income-tax rates are lower than personal ones. However, if your company makes very little net profit — as often happens in the first few years — you often pay less in personal taxes than you would if the business was incorporated.
One of the major reasons for this is personal exemptions and credits. You can protect some of your profits on your personal income-tax return by claiming credits for you, your dependents, and child care costs. You may also claim the mortgage interest that you pay on your house. That can all offset earnings if your business is a simple sole proprietorship or partnership.
On the other hand, if your company is incorporated
, you must pay the corporate tax rate on every dollar of taxable net profit. Once the business is highly profitable, the tax benefits of incorporation kick in.
One of the main reasons frequently cited for incorporation is to protect a company’s owners and their personal assets from any legal liability associated with the business. However, that isn’t how incorporation works. First, you may be held personally liable for any action you take or don’t take in your role as business owner. You can’t shield yourself from that.
If there are multiple owners, you can set up a structure, such as a limited liability company (or LLC), that can protect you from the actions of the other owners. You are protected from debt collectors, including the IRS, as long as you don’t sign the protection away. For example, a bank cannot come after your personal assets to satisfy a corporate bank loan; however, if the bank required you to sign a personal guarantee, it can attach your personal assets.
So, how do you know when the time has come for your business to take the next leap?
The first step is to consult with your accountant. Your accountant understands your particular tax situation and the company’s exposure to risk. He or she can also advise you on the different business structures (limited liability company, S corporation, or C corporation) and help you choose the one that best meets your current and future needs.