Should Your Small Business Incorporate?

 In Legal

An important decision all small businesses must make is how to structure it. The structure chosen affects many legal aspects of your business. In particular, it affects how the business is taxed and who is liable for debts. Because incorporation is a lengthy process and requires certain fees paid, it’s important to understand what exactly a corporation is and its different forms. Our sponsor Legal Services Link has pointed out everything you need to know about incorporating a small business.

Corporations

A corporation is a completely independent legal and tax entity, entirely separate from those who own, control, and manage it. As a result, corporations pay their own taxes on corporate profits, and owners pay personal income tax only on salaries and bonuses paid to them from the corporation.

A corporation typically provides the greatest protection for business owners who have potentially significant liabilities, incur substantial business debts, and/or want to ensure they protect their personal assets. Because of the separate status of a corporation, the personal assets of the business owners should not become exposed in the event of a lawsuit or default on a business debt.

Starting a Corporation

Corporations must file Articles of Incorporation or Certificate of Incorporation to begin operations, signed by the incorporator and incorporators. Individual states require specific information to include, but typically, the Articles of Incorporation include basic information about the company, including the official name and address of the business, corporate purpose, name and address of the registered agent, stock information (including the number of shares of stock authorized and the par value of those shares), and the names and addresses of the corporation’s Officers and Directors.

Some states also require corporations to maintain and adhere to bylaws, which define the company’s structure, individual roles and governance, voting rights, and responsibilities of directors, and also, to hold and document periodic meetings to discuss corporate business.

There are two main types of corporations to consider when starting a new business: S corporations and C corporations.

S Corporations

The S corporation is typically referred to as a “closely held corporation.” They are usually used for small businesses. S corporation can generally have no more than 100 shareholders by law. Officers and shareholders of an S corporation are not personally responsible for the debts and liabilities of the corporation, and there is no self-employment tax imposed on each person’s share of the business’s net income, but shareholders must file a form with their personal tax return called a K-1 form.

The K-1 form reports each shareholder’s share of income, losses, deductions and credits from the corporation. This same information is used to fill out the individual shareholders’ tax returns. Shareholders in an S corporation receive a reasonable salary from the corporation in combination with a portion of the profits as a distribution. This income is treated as net income under the K-1. Shareholders pay self-employment tax only on their salary. They may, however, be liable for regular income taxes on their portion of the corporation’s income. This sometimes includes income not distributed.

C Corporations

C corporations exist mainly for larger businesses. Use this if you want to raise capital for your business, take on multiple investors, and/or intend to make shares of your corporation available to the public on the open market.

Income from a C corporation is taxed twice. Once is at the corporation level, when the corporation pays taxes on its profits at a corporate rate. Then, it is taxed again on the individual shareholder level. The shareholders pay taxes on distributions based on the individual’s tax rate.

C corporations allow for many more tax-related deductions than S corporations. In order to obtain those deductions, however, the corporation must meet specific requirements. Some benefits that may be deductible on a corporation’s tax return include the costs of:

  • Health plans
  • Life insurance
  • Cafeteria plans
  • Assistance with educational expenses.

In some cases, in order to be eligible for deduction, the corporation must offer the same benefits to all employees and cannot provide special benefits to some employees while excluding others.

C corporations can also offer a lower tax rate. Consult a tax and accounting professional to determine if that is the case for your particular business.

Should You Consider Incorporation?

There are plenty of legal requirements a business owner must adhere to if they choose incorporation. It will, however, offer you a number of protections. Ready to adhere to laws and requirements of incorporation? Then incorporation may be the right structure for your business.

More on Incorporating Your Small Business:

Pros and Cons of Turning Your Small Business into a Corporation

Nonprofit Startups Can Use Alternative Corporate Structures

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