Money Girl explains the pros and cons of incorporating your small business, and when to consider it.
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.
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.