Incorporating a business can be a great way to save money on annual taxes, in addition to the protection it offers you from liability – and if you want your business to have a separate legal identity distinct from you, incorporation is crucial. However, there are some steps you need to take to ensure that the process goes smoothly, and that you meet all legal requirements. Furthermore, it’s especially important that you choose the right type of corporation for your small business.
Types of Corporations
When you incorporate a business, there are a number of steps you need to take. First and foremost, you must determine which type of legal entity you wish to form:
- S Corporations. If you form an S corporation, the profits and losses from the business “pass through” to the owners. This means the corporation itself doesn’t pay taxes, and all income must be distributed amongst the owners or paid out, after which taxes are paid on it by the recipients. S corporations also provide protection from liability.
- C Corporations. C corporations can result in double taxation, as the corporation pays taxes and the owners pay taxes. However, C corporations can still be the right choice for some businesses, especially large companies with many owners. C corporations provide protection from liability as other corporations do, and they also offer the most flexibility as far as a business having multiple owners and retaining corporate profits.
- Professional Corporations. Referred to as “PCs,” professional corporations can be designated as either C or S corporations. These are typically restricted to doctors, lawyers, accountants, and other professionals. In many states, when you form a professional corporation, all owners are required to have the appropriate professional license. For example, a doctor cannot incorporate with a non-doctor. PCs give you flexibility in how you are taxed on the income the business earns, and they also provide protection from liability by creating a separate business entity.
- Limited Liability Companies. Limited liability companies, or LLCs, are a hybrid of a corporation and a partnership. The rules for LLCs differ by state, but in general they can be formed by a single person or by multiple parties. Like a corporation, an LLC provides limited liability to individuals. LLCs also use the pass-through rules of S corporations. There is no limit to the number of individuals who can form an LLC, although some states preclude doctors, lawyers, and certain other professionals from forming this type of business entity.
How to Choose the Proper Corporate Structure
Choosing the right corporate structure can be complicated, and depends on the specifics of your situation. You should generally seek legal advice to do so. A lawyer can also help you with the legal steps of incorporation, including registering your business name and filing the appropriate paperwork with your local authorities.
With that said, there are some general guidelines to consider:
- LLCs and S corporations can both work well if you, as a business owner, want to include profits and losses on your personal income taxes. If you are not concerned about being easily able to sell your stock on the open market, this business entity may be best for you. Many small businesses operate as either LLCs or S corporations, with LLCs providing the option to have more shareholders and fewer regulations than S corporations. For example, law firms and accounting firms often operate as LLCs or S corporations.
- C corporations can work well if business owners do not want to include the income and losses of the corporation with their personal taxes. For large businesses with many owners, or for businesses that want to issue stocks to employees easily and sell stocks openly, C corporations may be the best choice. Many of the largest companies in the United States operate as C corporations, including any of the companies traded on the New York Stock Exchange.
Costs of Incorporation
Once you begin the process of incorporating, you should expect it to take several weeks to file and process the paperwork and receive your articles of incorporation and other documentation. The specific timeline varies by state, and you may be able to pay extra for a “rush filing.” However, in general, you can expect it to take about a month to get your incorporation documents from the time you submit your forms.
Keep in mind, the cost of incorporation varies by state and by the type of corporation that you are forming. The costs also vary depending upon whether you file the paperwork yourself or whether you consult an attorney. The fees and expenses associated with incorporating may include:
- Articles of Incorporation Filing Fee. These must be filed with the Secretary of State, and it generally costs anywhere from $100 to $250 to file depending upon the state.
- Governmental Filing Fees. These fees vary depending on where you live and the type of business you are operating. Usually, you must pay between $50 and $200 for additional government filings on top of the costs of filing the articles of incorporation.
- Attorneys Fee. The costs of working with an attorney depend upon where you live and the level of assistance you need. Attorneys can charge anywhere from around $50 per hour to upwards of $300 per hour.
- Tax Preparation Fees. Again, these fees vary depending on which accounting firm you work with, and they can be significantly more expensive in certain areas of the country than others. In general, though, a fee of approximately $1,000 for the preparation of a corporate return is customary and reasonable.
After you have started your corporation, there will be annual fees that vary by state and by type of corporation, but these fees usually do not total more than a few hundred dollars.
How to Incorporate Your Business
While you can turn to a lawyer to take care of the technical aspects of forming the corporation, there are still steps you need to take to get the corporation up and running – and ensure that you will benefit from it.
- Set a Reasonable Salary for Yourself. When you incorporate, you can’t simply take money out of your business. You have to pay yourself a set salary. Taking a salary lower than the full amount the business earns and paying yourself the rest in dividends or distributions can be a source of tax savings since you don’t pay self-employment taxes on the distributions. However, the salary must be appropriate for your job. Check customary salaries for your profession in your area, and make sure you can justify your salary should the IRS inquire.
- Enlist the Help of a Payroll Service. When the business pays your salary, it needs to withhold payroll taxes and pay those to the IRS. The payroll process can be time-consuming and complicated. Therefore, it is often best to pay a small fee for a payroll service to withhold what’s appropriate, and write you a check.
- Consider Offering Employee Benefits. One of the biggest financial advantages of incorporating is that the business can offer employees (including you) benefits, such as retirement plans and health insurance. The corporation can also deduct the costs of benefits. Providing benefits is complicated if you employ multiple people, but may still be advantageous. Your lawyer can guide you on this issue.
- Separate Your Personal Finances From the Corporation. This is extremely important to prove the legitimacy of the corporation if the IRS ever questions you. Treat the corporation as if it were any other employer, and don’t take money outside of your salary or formal bonuses.
- Obtain a Minute Book to Record Notable Events. Corporations have to keep minutes and have an annual meeting. You should also record notable events, such as the purchase of a new piece of equipment, in your minute book.
- Switch Business Accounts Into the Corporation’s Name. Remember, you and your business are no longer one and the same in the eyes of the law. Everything the business buys or owns needs to actually belong to the business. You should even be sure to change magazine subscriptions for trade publications into the business’s name. This provides further evidence that your corporation is legitimate.
- Set a Reasonable Rent if You Own the Office Space. If you own your own office space, you are effectively the corporation’s landlord. Therefore, the corporation needs to pay you for the use of the office space. This is another way to get money out of the corporation without paying self-employment taxes.
- Hire an Accountant. You don’t want your lawyer to do your taxes, as legal fees are often significantly higher than accountant’s fees, and your lawyer is likely not trained to prepare taxes. Get an accountant that specializes in small business tax issues.
The IRS is concerned with people setting up corporations (especially S corporations) solely to benefit from tax savings. As such, you need to be careful to follow all the steps, and that you truly treat your corporation as a separate legal entity distinct from you.
Benefits of Incorporating
Going through every step to incorporate your business is a lot of work. However, there can be significant advantages:
- Protection From Liability. If your corporation is sued, your personal assets won’t be at risk. You also won’t be personally responsible for debts taken on by the corporation.
- Tax Savings. When you earn money from self-employment (1099 income), you have to pay Social Security taxes and Medicare taxes on all income earned up to $106,000. When you incorporate as an S corporation and take a portion of the profits as dividends or distributions, you don’t pay Social Security on those distributions. Distributions or dividends are essentially a payback for the investment you made in the business and the risk you took in investing – just like when you invest in any corporation on the stock market.
For some businesses, the significant savings and added peace of mind is well worth going through the incorporation process.
Before you incorporate, seek advice from a lawyer or accountant to make sure that incorporating actually makes sense and will be beneficial. Also, run a cost-benefit analysis to determine whether the initial and ongoing time and expense commitments are worth it.
Once you make the decision, be very careful in how you behave as a corporation in order to avoid trouble with the IRS. It’s a completely different game than being a sole proprietor, and the IRS will review your corporate returns with additional scrutiny.
Have you ever incorporated a business?