Self-Employed? When and Why to Incorporate Your Small Business
Money Girl explains the pros and cons of incorporating your small business, and when to consider it.Â
A Money Girl reader and podcast listener named Gail asks, “When and why should a self-employed person go through the trouble of incorporating their small business?”
This is an important question that many small business owners, freelancers, and contractors struggle with. But don’t worry–in this episode, I’ll clear up the confusion, and let you know when you should incorporate your small business.
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What Is Incorporating?
Although “incorporating” a business sounds very complicated, it’s simply an umbrella term that describes the process of declaring that your business is a legal entity that’s separate from you as an individual. You have several options, such as becoming a C corporation, an S corporation, or a limited liability company (LLC.)
While incorporating your venture is generally not a legal requirement, it can give you strong protections that every small business owner, freelancer, and part-time side worker should consider. I’ll cover 5 major advantages of incorporating in just a moment.
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What Is a Sole Proprietorship?
The structure you choose for your business or side hustle can be changed as it grows and matures. For instance, most small businesses start out as a sole proprietorship, and may become a corporation or an LLC as they hire employees or accumulate more business assets.
If you make money as a one-person business—such as a writer, photographer, designer, commissioned salesperson, or craftsman—and are not on an employer’s payroll or incorporated, you are a sole proprietor by default. So it can be easy to forget that staying a sole proprietor may not always be in your best interest.
What Are the Advantages of Incorporating?
Here are 5 major advantages of incorporating your small business or part-time venture:
Advantage #1: Protects your personal liability
Being a corporation or an LLC limits your personal liability when trouble rears its ugly head in your business. As I previously mentioned, an incorporated company is a completely separate entity from you and your personal assets. So even if you go out of business, you aren’t likely to lose your personal property.
On the other hand, remaining a sole proprietor means that you can be held personally liable for business-related activity or debt. For instance, let’s say you lose a lawsuit for breach of contract, or don’t make enough profit to pay a business loan. The injured party or creditor can go after your business and personal assets for compensation.
In other words, your personal belongings—such as your bank savings, investments, real estate, and vehicles—are always at risk when you’re a sole proprietor.
Your personal belongings—such as your bank savings, investments, real estate, and vehicles—are always at risk when you’re a sole proprietor.
Advantage #2: Gives you tax advantages
There are different types of corporations that offer different tax benefits. A regular or C corporation is taxed differently than any other business structure because it must pay its own income tax on profits.
Shareholders who receive income from a C corporation must also pay personal income tax, which sets up a situation known as double taxation. Since a C Corporation is more complex, it’s generally recommended for larger businesses with employees.
In contrast, an S corporation is similar to a C corporation, but only requires you to pay tax as an individual. Income flows through an S corporation without being taxed, until it’s claimed as income by shareholders. This avoids having double taxation.
Here’s an example that demonstrates the difference in taxation between a sole proprietorship and an S corporation: let’s say you are a virtual assistant making $50,000 a year as a sole proprietor. You’d owe ordinary income tax plus self-employment tax (for Social Security and Medicare) on the full amount.
But if you were a single-owner S Corporation and made $50,000 a year, you’d have the option to leave some money in the business, or to take distributions, which are not subject to the self-employment tax.
For instance, you might choose to take $30,000 in salary and $20,000 in distributions. In that case, you’d avoid paying self-employment tax on $20,000, which could save a bundle when compared to being a sole proprietor.
Corporate taxation is a very complex topic, so I strongly recommend that you discuss your business in detail with a tax professional before incorporating.
See also: 3 Best Free Tools to Manage Money (for Home or Business)
Advantage #3: Allows you to take more business risk
Since incorporation separates you from your business, you might feel more freedom to swing for the fences and take additional business risk that makes growth possible. The only loss you might experience would generally be your original investment in the company.
The main downside is that there are fees to get set up and maintain your corporate status each year, which vary depending on the state where you do business.
Advantage #4: Gives you a credible identity
Having “inc” or “corp” after your business name gives you credibility as a corporate entity. Additionally, since a corporation is its own entity, it can outlive you.
Depending on your field or industry, some customers or clients may prefer doing business with a corporation rather than a sole proprietor. And you may attract higher-quality employees.
Advantage #5: Gives you more options for funding
If you’re interested in attracting equity investors, you can raise capital by selling shares of corporate stock to grow your business.
What Are the Disadvantages of Incorporating?
Although there are many advantages of incorporating, there are also some disadvantages. The main downside is that there are fees to get set up and maintain your corporate status each year, which vary depending on the state where you do business. Plus, your annual tax preparation gets more complicated, and the cost may go up.
When Should You Incorporate Your Business?
The answer to when you should incorporate your business depends on many factors, such as your risk of getting into a lawsuit, your tax liability, the type of business you do, and your business goals.
If you’re engaged in a risky business—such as being a gym owner, having a dental practice, or selling edible products—you’ll need plenty of protection and should be incorporated, in addition to having business insurance.
But for other low-risk businesses, such as providing editing services or being a graphic designer, simply having business insurance may keep you safe and give you peace of mind as a sole proprietor, especially if you don’t have employees.
Since the needs of every business owner are different, and the tax law varies from state to state, set up a consultation with a business attorney or a tax professional to discuss all of the issues that should affect your decision to incorporate.
A good time to incorporate is at the beginning of a new year, so you avoid having to file 2 sets of tax records: one as a sole proprietor and one for the months following your incorporation. So, make it a goal to consider your potential liability in business and fully investigate whether you should incorporate your small business before the end of the year.
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Incorporation Seal Stamp image courtesy of Shutterstock
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
