Moving from a sole proprietor to S Corp status (the most common small business structure) offers potential tax and other benefits. But a sole proprietorship gives you more freedom to move money and is cheaper to operate. So when, if ever, should you incorporate? It depends on where you are in the growth and lifecycle your business and what you need. Each type has its own advantages.
“The chief benefit of a sole proprietorship is ease of operation,” notes Janet Attard, founder of small business intelligence site BusinessKnowhow.com. “There’s no special paperwork to file other than your quarterly taxes, a Schedule C and a Schedule SE—to pay your own Social Security and Medicare—at the end of the year. There are no monthly payroll tax deposits or quarterly payroll tax returns, and no separate corporate return to file. Since all net income belongs to you, you can easily take money out of the business. There are low start-up costs and you can use losses to offset other income on your tax return. And it’s your baby—no one else can tell you how to run the business.”
That said, as you grow and take on more employees and outside contractors or do more work with larger corporate customers, you may want the protection that incorporation offers. As an S Corp., you gain liability protection. As a sole proprietor, if you hire someone who makes a costly mistake, you’re personally liable for their actions. Under the rules of incorporation, unless it can be proven that you were negligent regarding an employee’s actions, you have liability protection.
But, Attard points out, there are other benefits as well. One not readily evident is your perception in the marketplace. “When you incorporate, you immediately look more professional and bigger,” she says. “At one point, we had the opportunity to partner with AOL, so we incorporated to look more professional. Larger companies want to know you’re in it for the long haul and sole proprietorships can appear temporary in their eyes.”
Other advantages include greater ease of ownership transfer for incorporated companies vs. sole proprietorships and real tax benefits. In an S Corp structure, you are employed by your own corporation. You get paid a salary and have payroll taxes withheld on your salary. Any profits (all corporate income, minus all expenses including salaries) left at the end of the year then pass through to the owners as unearned income, which is not subject to the self-employment tax. If you are the sole shareholder in an S Corp, pay yourself $75,000 a year, and have $20,000 in profits at the end of the year, you’ll only pay income taxes on the $20,000, instead of income taxes plus self-employment. One caveat: The salary owners take must be considered “reasonable” in the eyes of the IRS, which it considers “fair compensation for the work performed.”
One increasingly popular derivation of the S Corp is a Limited Liability Company (LLC), which offers similar liability protection, yet owners still pay self-employment tax. As far as ease of management goes, the LLC falls somewhere in between a sole proprietorship and an S Corp.
Incorporating a business tends to be fairly simple and inexpensive, with the key documentation being your state’s Articles of Incorporation, your corporate bylaws along with a first-year franchise tax payment, various government filings and licenses and attorneys’ fees. In fact, you can even incorporate online through such sites as BizFilings, MyCorporation, The Company Corporation and many others.
No matter which you structure you choose, Attard recommends consulting an attorney or accountant before making any decisions. “If you spend a couple hundred dollars and get good, consultative help up front, it can save you thousands later on down the road should you have legal issues,” she says. “When we shifted to S Corp status, my accountant handled it for me. It takes about 10 extra minutes a quarter to operate this way and I count on my accountant to know the tax ins and outs that I don’t want to learn.”