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When is it time to convert to a corporation? What are the benefits of incorporating, and what are the steps involved? If you are an entrepreneur or sole proprietor, or you're planning to launch a new business, you may have some of these questions. Setting up a corporation has many benefits, but there are also costs involved—a cost-benefit analysis can help you decide if incorporation makes sense for your business.
Liability protection is the classic reason to incorporate—every state recognizes incorporation as a legitimate way for business owners to limit or eliminate personal liability. As the business owner, incorporating offers protection for your personal assets. For the most part, your personal assets are off limits in the event of a judgment against the business (keep in mind that while incorporating can protect you from some liabilities, it does not protect you from others like negligence or fraud).
For businesses that incorporate, there are also tax savings to consider. If you're self-employed, you typically pay higher self-employment taxes than if you were an employee of a company. An S-Corporation can reduce these taxes by allowing you to designate some of your income as salary and some as a distribution.
If you incorporate as an S-Corporation (no more than 100 shareholders), you are liable for self-employment taxes on the salary portion of your income, but pay just ordinary income tax on the distribution portion. So long as you designate a reasonable amount of your income as wages, you don't have to pay self-employment tax on your share of the business's profits. If you go this route, the IRS may take a close look at your taxes, so be sure to talk to your tax professional first to determine whether this is the right strategy for your business.
Forming a corporation involves more administrative paperwork than when you operate as a sole proprietor. It also costs money and time to form and maintain a business entity. There is an initial cost to form the corporation (the exact amount varies based on the type of entity you're forming), plus costs to maintain the entity from year to year. Even if your business has no revenue or loses money in the preceding tax year, you're still responsible to file a tax return every year. If you decide not to file a return, you'll have to pay the minimum franchise tax plus penalties and interest for paying the tax late.
Incorporating involves organizing legal papers (including articles of incorporation, by-laws, and organizational minutes) and filing these documents with the Secretary of State's office. You can do this yourself, or hire a professional who can help you manage the details and prepare and file required documents with the state.
There is also a timing factor to consider: The end of the year is an especially good time to incorporate. Set your new corporation to go into effect on January 1, and you'll start out the new year with your business protected and save yourself some hassle at tax time (you'll only have one set of tax forms to file for that year, instead of two sets of forms to file if you incorporate mid-year).
Questions about incorporating? We can help—contact us today to learn more about the process for your business.