Incorporation… Sounds fancy, doesn’t it? And while the word “incorporate” conjures up images of high rise buildings, swanky offices, and designer suits—incorporation is not just for the big guys. Even a solopreneur working in their sweat pants from the couch can incorporate their business.
Wait! Incorporating my business doesn’t even require real pants?
It’s true! Because the decision to incorporate your business is less about the size and scale of your business and more about what you do and your long-term goals.
Many small business owners default to NOT incorporating because they don’t know what it actually means. But the decision to incorporate, or not, should be made intentionally.
Have I piqued your curiosity? Then read on to learn if incorporating could be beneficial for your business. if you should incorporate your business.
What does “incorporation” mean?
First things first—what does it mean to incorporate your business?
Incorporating your business means that you’re setting up your business as its own entity recognized by the state. Incorporating your business is not the same thing as registering your business. When you register your business, you notify your state of your business’s existence so you can operate legally, but you don’t create a separate legal entity for your business. That only happens when you incorporate your business.
As a sole proprietor or general partnership, there’s no separation between you, the owner, and your business. You (and your assets) are personally on the hook for taxes, debt payments, credit, and money owed in a legal dispute. As an incorporated business, your business is separated from you and becomes its own legal entity.
Incorporation is a general term that refers to going through the legal process of separating your business from yourself.
Note: For the purposes of this article, we are defining incorporation as creating a state-recognized legal entity for your business and are including LLCs in the article. While LLCs are technically unincorporated entities from a federal perspective, states recognize LLCs as separate entities.
Incorporation doesn’t necessarily change how you’re taxed. This is because the legal entities recognized by the state are different than the legal entities recognized by the federal government (totes confusing—I know!). For example, while a single-member LLC is recognized as a legal entity by the state, the IRS classifies it as a disregarded entity and you are taxed as an individual, just like in a sole proprietorship.
How you’re taxed by the federal government depends on which legal structure you adopt. When incorporating your business, you can choose from:
Should you incorporate your business?
That depends on several factors. Here are four questions to ask yourself before incorporating your business.
1. How much legal protection do you need?
As an unincorporated business, your personal assets and your business assets are the same. As an LLC or incorporated business, you’re protected from personal liability if your business is sued. There are exceptions to this, but in general, the owner has a legal shield between their business and their personal assets.
Also, as an LLC or incorporated business, you’re not personally liable for your business’s debts unless you sign a personal guarantee. This means that only the assets owned by your business can be used to pay back debts. This is especially important if you have personal assets, like a home, car, or other personal property.
How much legal protection do you need? That depends on your industry and what products or services you offer. For example, a virtual assistant’s legal risk is much lower than someone who sells products for consumption.
Consider how at-risk you are for potential legal issues in your business:
- Do you sell or make products that will be ingested or applied to a person’s body? These could be food products, vitamins, supplements, herbs, or skin care products.
- Do you have a physical location that customers visit where there is a risk of an accident?
- Do you have employees and do you, personally, want to be liable for their actions?
If you have significant legal risks in your business, you may want to incorporate for the legal protection.
2. How much money do you make?
For some business owners, incorporation makes sense from a financial standpoint. Both S corps and C corps are taxed differently than sole proprietors. These tax differences can have a huge financial benefit for business owners.
When you’re taxed as an S corp, you only pay income tax on your business’s profits. Unlike an LLC or sole proprietor, whose owners pay income tax and self-employment tax on their profits, S corp owners do not pay self-employment tax, which is 15.3% of their profits.
However, as an S corp, you must pay yourself a “reasonable compensation” through payroll. Your business will pay half of your payroll taxes (7.65%), and you will pay the other 7.65% through paycheck withholdings. This means you are only paying the equivalent of self-employment tax on your salary, not your total profit.
As a C corp, your entity pays corporate tax on its profits and the owners pay income tax only on the dividends they’re paid. As the owner, you’re not taxed on the entire profit of your business, but rather just on the profits that are distributed to you.
If you only take a salary from your C corp (which is subject to payroll taxes) and not dividends, then only your corporation will pay taxes on the profits. Under the new tax bill, the corporate tax rate has decreased from 35% to 21%, which could create even more financial savings.
Generally speaking, if you make more than $60,000 in taxable profits a year, it’s possible that incorporation could save you big bucks on your taxes. If you do meet this threshold, talk to a tax professional to see if incorporation makes sense for you.
3. Does your business need its own credit?
When your business is incorporated, your business becomes its own entity with its own credit. Just like individuals, businesses have their own credit reports and scores. And just like individuals, businesses can build their credit over time.
When your business has its own (hopefully good) credit, you can:
- Apply for business loans
- Open a business credit card
- Open a business line of credit
- Establish trade lines (aka payment terms) with your vendors
And you can do all of this in the name of your business. That means your personal credit does not get mixed up in your business credit. This also means that you’re not personally liable for your business debts.
You might be thinking, “I don’t need a business loan!”—but keep in mind that credit takes time to build. You might not need a loan now, but will you need a loan five years from now?
For example, maybe you have a small online boutique and your dream is to open a brick-and-mortar location. You might not be ready for that right now, but if it’s in your five-year plan, it’s good to start building your business credit early so you can qualify for a business loan down the road.
If you think you’ll need a business loan or to establish payment terms with your vendors in the next five years, consider incorporating your business now so you have time to build your business credit.
4. What’s your grand plan for your business?
As business owners, it’s easy to get caught up in the day-to-day of our business and forget about our long-term business goals. Yet, your long-term goals should factor heavily in your decision to incorporate your business.
- Do you plan to eventually sell your business? Then you’ll need to incorporate your business so you’ll have something to sell. Remember, when you incorporate your business, it becomes its own entity, which exists whether you’re the owner or not.
- Do you plan to pursue capital funding and investors? Investors are unlikely to invest in an unincorporated business and prefer to invest in businesses that will have the capacity to issue stock.
- Will you pursue contracts with clients who require incorporation? Some companies won’t work with unincorporated entities. Incorporating your business opens up more possibilities in terms of customers and can give your business more credibility.
- Will you be building a brand that needs to be protected? When you incorporate your business, you register your business name with the state. Once registered, no one else in the state can use the name of your business. If you’re building a business that will rely heavily on brand recognition, protect your brand by incorporating your business.
Incorporation can be beneficial for the big and little guys alike… even the ones that don’t wear real pants. Regardless of if you decide to incorporate or not, DECIDE what you’ll do. Don’t let the word “incorporate” intimidate you from making the best decision for your business.
Going to go all in? Then check out our guide that walks you through the first step in the process, choosing a legal entity, and get your incorporation on.