If you’re a sole proprietor who has been in business for a while, you may begin to wonder if and when you should incorporate yourself.
There are a few telltale signs indicating whether a sole proprietor might want to consider incorporating his or her business.
After all, your business structure can have a significant impact on your bottom line.
Before you make this important decision, you’ll need to know how to choose a business entity, the benefits of incorporating yourself, how to incorporate yourself, and what’s required after the incorporation.
Should I incorporate myself?
As a sole proprietor, you’re personally liable for any debt or lawsuits stemming from your business.
By incorporating, you’re creating a completely separate business entity that removes at least some—if not all—of the liability burden away from you personally.
This prevents your home and other personal assets from being at risk.
Below are a couple of signs to incorporate your business:
- You wonder if you can personally pay back any debt from your company
- You worry about being able to personally manage any lawsuits from employees or customers
Other reasons for considering incorporation are if there are multiple founders, if you want to raise capital, or if you want a clear-cut exit strategy in place for your business.
All of these would be legitimate reasons for forming a corporation.
Always consult a tax professional, however, when trying to determine what is best for you and your business.
How do I choose a business entity?
Before you can decide which business entity is right for you, it’s a good idea to review the different business entity options.
1. Sole proprietorship
A sole proprietorship is the most basic and easiest type of business entity to set up and run.
You simply establish a ‘doing business as’ (DBA) name.
This is a great option for small businesses that don’t have any substantial assets.
A partnership is when two or more individuals go in together to form a company.
Partnerships can be established with different levels of personal liability protection.
With a partnership, the profits and losses are reported on each of the individual’s personal tax returns.
This is known as a pass-through entity.
3. Limited liability company
A limited liability company (LLC) also offers a degree of personal liability protection.
An LLC is a good option that falls between a partnership and a corporation.
Corporations fall into two categories: C or S corporation election.
An S corporation election provides personal liability protection and acts as a pass-through entity taxation to your personal tax return.
While C corporations offer the most personal liability protection, the taxes are also much higher.
Corporate profits are double taxed at the personal and business level with C corporations.
What are the steps for incorporation?
If you decide to incorporate, below are the steps involved in the incorporation process, along with some other recommendations for setting up your business.
Step 1: Create the business entity
First, you’ll want to create the business entity by doing the following:
a. Establish the state where you will incorporate
This may be your home state, but you must have an active office in the state you choose to incorporate your business.
b. Choose a business name
Your business name must be different from the name of an already-registered business to avoid getting into legal problems. It would also help if you considered securing the authenticity of your brand by registering your name as a trademark which prevents other entities in the country or globally from using your business name, depending on the scope of your protections. Using a good business name generator can help create a distinct and memorable name that suits your brand.
c. Generate and file an Articles of Incorporation
This must be with the state your business is headquartered in.
The Article of Incorporation is usually filed and issued by the Department of Commerce or Secretary of State and includes information such as location, the purpose of the company, and shares of stock.
d. Pay the fee required for incorporation
Fees for incorporation vary by state.
e. Get your Certificate of Incorporation
The state will process your filing and issue you a Certificate of Incorporation.
f. Designate a president, treasurer, officer, director, chief financial officer, and shareholder
You can fill these roles yourself or hire someone to take on the responsibility.
g. Appoint a registered agent to receive legal paperwork on behalf of the company
The registered agent must have a physical address in the state where the business is registered.
While we’re on the topic of registered agents, be on the lookout for Shoeboxed‘s upcoming registered agent service!
h. Conduct a first directors’ meeting
This meeting will allow you and your board members to discuss plans and issues within your company.
i. Draw up by laws
These will define the roles of the officers, directors, and shareholders.
j. Issue stock certificates
Stock certificates should be issued to anyone who is an owner of the corporation.
Steps for incorporation may vary by state, so it’s best to check with the Secretary of State in the state you plan to incorporate to make sure you’re fulfilling the requirements.
Step 2: Obtain a tax ID number from the IRS
Once the business entity is created, you’ll want to obtain an Employer Identification Number (EIN) from the IRS website.
This is done by using the IRS form SS4.
Step 3: File S Corp election
If you choose an S corporation election, you’ll need to fill out IRS Form 2553 and send it to the IRS.
This election needs to be filed within 2.5 months from when your entity was established.
Step 4: Obtain state tax IDs
You will also need to obtain an employer account number or tax ID from the state.
These account numbers must be provided to your payroll service.
If you’re in the business of selling retail goods, you will also need a sales tax ID number.
Step 5: Obtain state and city licenses
You may have to apply for a business license with the state.
You also need to register for a business license with the city and pay the city’s business tax.
Good practices to follow
Once all of the legal requirements are fulfilled, there are some good practices to follow that will make your corporation run smoother and more efficiently.
1. Separate your business and personal finances by establishing a business bank account
Once you have your federal tax ID number, you can set up a bank account just for your business.
You should also apply for a business credit card.
Tax time will be a much simpler process by taking these steps since this will separate all of your business activities from your personal transactions.
2. Acquire a payroll service
Signing up with a payroll service will take a burden off your shoulders.
Not only will they handle payroll, but they will also take care of the payroll tax returns that need to be filed quarterly to the IRS and state.
3. Look into opening a self-employed 401k
Opening a self-employed 401k is highly recommended.
When you’re self-employed, it’s very important that you take the initiative to start saving for retirement.
How are corporations treated when it comes to taxes?
Your business will be treated very differently when it comes to taxes once it’s incorporated.
Instead of filing a Schedule C and reporting any net loss or profit on your individual tax return, the corporation will file a business return.
C corporations pay taxes on corporate profits and file taxes using IRS Form 1120.
S corporations usually don’t pay taxes on the corporate level, but file using IRS Form 1120S.
Profits from S corporations, instead, are passed to the shareholders.
The tax information is issued on Schedule K-1 and provides all of the information needed for the individual’s tax return.
1. Tax breaks
When it comes to taxes, you and your business will file separate income tax returns.
As the business owner, your income will either come from a salary that you pay yourself or from dividends taken off of the profits from the corporation.
As a sole proprietor, you can’t deduct any salary you pay yourself, however, after incorporating, compensation can be deducted by the corporate entity.
Shareholders typically pay tax on their compensation, the distribution of dividends by a C corporation, or pass-through profits from an S corporation on their individual returns.
2. Self-employment tax liability
Self-employed individuals are required to pay self-employment taxes.
By incorporating, you typically pay less tax for self-employment.
For example, if you’re a limited liability company and taxed as an S corporation, you won’t have to pay any self-employment tax.
As far as corporations go, you can incorporate them as a C corporation or as an S corporation.
With a C corporation, you are considered an employee so you don’t pay any self-employment tax.
The corporation pays the employer’s share of the tax for self-employment.
With the S corporation, you’ll pay self-employment tax on the salary you pay yourself, but not on the distributions.
3. Tax deductions
If you’re incorporated, there are also many tax deductions that you can take advantage of.
With a corporation, the actual expense that it cost you to run your business can be deducted from your business income.
This in itself can significantly reduce the tax liability of your business.
What are the benefits of incorporating yourself?
Other than tax savings, there are other significant benefits to incorporating yourself.
1. Liability protection
When you incorporate, you add a layer of limited liability protection between your personal assets and your business activities.
When you incorporate yourself, you are creating a business legal entity that is separate from your personal affairs.
2. Lenders are more willing to work with corporations
Most lenders are more comfortable dealing with a corporation rather than a sole proprietor.
This is mainly due to the fact that corporations have access to more sources of capital, if needed, to pay off debt.
3. Easier to raise capital
Corporations can issue shares of stocks which is an easy way to raise capital.
4. Enhances the credibility of your business
Corporations are often viewed as more stable than sole proprietors or unincorporated businesses.
Individuals typically feel more secure and confident dealing with a corporation than a sole proprietorship.
Corporations send out the message that they’re in it for the long haul.
5. Unlimited lifespan
Corporations have an unlimited lifespan and can exist indefinitely, even if the shareholders die or leave the company.
What are the annual corporate requirements?
Not only are there a lot of things to keep in mind when incorporating your business, but there are also annual requirements that need to be considered.
1. File tax returns annually
Since S corporations are pass-through entities, there will be no tax due on the business return.
However, a federal tax return still needs to be filed for the business.
A K1 form passes the loss or profit to the individual’s personal return.
Depending on the state, you may also need to file a state tax return. And be careful for not submitting your taxes twice.
2. File annual report
You will also need to file an annual report with the state.
This ensures that records of the business remain updated regarding management and ownership.
Some states require an annual report every year while others require it every other year.
3. Annual meetings and minutes
Annual meetings and minutes are required on the federal and state level.
These documents don’t have to be filed with the state but must be kept on file.The information regarding annual meetings and minutes may be required if the business is ever audited, along with other supporting tax documents.
Frequently asked questions
Incorporating yourself is creating a business entity that separates your business from your personal affairs.
This is a way to protect personal assets.
Individuals incorporate to separate their business activities from their personal assets and finances.
Incorporating establishes a limit on personal liability and can potentially save on taxes.
Business owners either pay themselves a salary or take dividends from the profits.
Most lenders are more comfortable dealing with corporations rather than sole proprietorships.
This is mainly due to the availability of resources that corporations have access to when debts need to be paid off.
Knowing how to incorporate yourself is an important next step in the growth of your business.
Incorporating yourself separates your business from your personal finances, reducing your personal liability should anything go awry with your company.
Caryl Ramsey has years of experience assisting in different aspects of bookkeeping, taxes, and customer service. She uses a variety of accounting software for setting up client information, reconciling accounts, coding expenses, running financial reports, and preparing tax returns. She is also experienced in setting up corporations with the State Corporation Commission and the IRS.
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