Should You Incorporate Your Business? Here’s How to Decide.

Incorporation sounds nice, doesn’t it? The word conjures images of high rise buildings, swanky offices, and designer suits. But the truth is, even solopreneurs working in their sweatpants from the couch can incorporate their business.

The decision to incorporate your business is less about the size and scale of your business and more about what you do and what your long-term goals are.

Many small business owners default to not incorporating because they don’t know what business formation actually involves. In this article, we’ll clear it up. Read on to learn if incorporating could be beneficial for your business.

What does “incorporation” mean?

Incorporating your business means setting it up as its own entity recognized by the state. This 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 with incorporation. To incorporate, you file articles of incorporation (called articles of organization or a certificate of formation for an LLC in some states) with your state.

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 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 aren’t corporations, states recognize them as separate legal entities.

Incorporation doesn’t necessarily change how you’re taxed. This is because the legal entities recognized by the state are different from the legal entities recognized by the federal government. 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:

• Limited Liability Company (LLC): A business structure that offers limited liability protection by separating the owners' personal assets from business debts and legal claims. By default, profits pass through to the owners' personal tax returns, and LLCs have fewer formalities than corporations.

• S corp: A tax election that lets an LLC or corporation pass income through to owners' personal returns. Among other eligibility limits, owners who work in the business must take a reasonable salary, and only that salary is subject to payroll taxes.

• C Corp (C Corporation): A legally separate business entity that pays its own corporate income tax. Shareholders are taxed again on dividends, which is called double taxation. C corps can have unlimited shareholders and issue multiple stock classes, which suits businesses seeking outside investment.

Each of these legal structures has its own tax considerations, so you’ll want to chat with a tax professional about which is best for you.

Should you incorporate your business?

That depends on several factors. Here are four questions to ask yourself before incorporating your business.

1. How much liability 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 (sometimes referred to as the corporate veil).

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 you need 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 can offer tax savings, depending on your profits.

S corp advantages

When you're taxed as an S corp, your business's profits pass through to your personal tax return, and you pay income tax on them. Unlike a default-taxed LLC or sole proprietor, whose owners pay income tax and self-employment tax on all of their profits, S corp owners pay payroll taxes only on their salary. Self-employment tax is roughly 15.3% of net earnings (12.4% for Social Security and 2.9% for Medicare).

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 payroll taxes on your salary, not your total profit. Keep in mind that running payroll and filing a separate S corp tax return adds costs and administrative work.

C corp taxes

C corps pay a flat 21% federal corporate tax rate on their profits. If you then pay yourself dividends, you'll pay personal income tax on those dividends too, which is known as double taxation. If you only take a salary from your C corp (which is subject to payroll taxes) and not dividends, only your corporation pays tax on the remaining profits.

Other tax considerations

Business owners who are taxed on a pass-through basis (sole proprietors, LLCs, and S corps) may also qualify for the qualified business income (QBI) deduction, which lets eligible owners deduct up to 20% of their qualified business income. You can learn more about eligibility and limits here.

Talk to a tax professional to see if incorporation makes sense for you. As your profits grow, the potential savings from an S corp election generally grow too.

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 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 won’t get mixed up in your business credit. It also means that you're not personally liable for your business debts, unless you sign a personal guarantee.

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 one in five years?

For example, let’s say you run 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?

It's easy to get caught up in the day-to-day of running a business and forget about long-term goals. However, 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 raise capital? Investors typically prefer to invest in businesses that can issue stock, and many prefer C corporations specifically. An unincorporated business is unlikely to attract outside investment.

• 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, which generally prevents other businesses from registering an identical name in that state's records. This isn't the same as a trademark, which offers broader protection. If you're building a business that will rely heavily on brand recognition, consider both incorporating and trademarking your name.

What are the ongoing costs of incorporating?

Incorporating usually comes with costs beyond the initial fee for filing articles of incorporation. Many states charge annual report fees or franchise taxes, and S corps and C corps have additional tax filing and payroll requirements. Check your state's requirements and factor these into your decision.

Incorporation can be beneficial for any size business. Regardless of whether you decide to incorporate or not, the important thing is that you make a decision.

Going to go all in? Then check out our guide to the first step in the process, choosing a legal entity, and getting incorporated.

FAQs

What is the difference between an LLC and an S corp?

An LLC is a state-level business structure that separates your personal assets from business debts, while an S corp is a federal tax election, not a business type. An LLC or corporation can elect S corp status so profits pass through to owners’ personal tax returns.

Can an LLC be taxed as an S corp?

Yes. An LLC can elect S corp tax treatment by filing IRS Form 2553, as long as it meets the requirements. These include no more than 100 shareholders, only eligible shareholders (generally individuals, estates, and certain trusts), and one class of stock.

Do LLC owners pay self-employment tax?

Generally, yes. By default, a single-member LLC is taxed like a sole proprietorship, so profits are reported on Schedule C and are subject to self-employment tax. Multi-member LLCs are taxed as partnerships by default. An LLC can elect corporate or S corp treatment instead.

Does an LLC fully protect my personal assets?

Not always. An LLC generally protects personal assets like your home and savings from business debts and lawsuits, but the protection has limits. The SBA recommends a written operating agreement, since an LLC that skips formalities can resemble a sole proprietorship. Business insurance can help fill coverage gaps.

How much does it cost to form an LLC or corporation?

The SBA says registering a business usually costs under $300 total, but the amount depends on your state and business structure. Many states also charge annual report fees, and some charge franchise taxes for LLCs or corporations. Check your state’s Secretary of State website for exact figures.