Friday, September 23, 2005

Why Incorporate Your Small Business?

Incorporation is an important step in the life of a business, but unfortunately the true value of incorporating a business is often not seen until the business faces a negative situation such as a lawsuit or bankruptcy.

A primary advantage of incorporation is the limited liability the corporate entity affords its shareholders (owners). Typically, shareholders are not personally liable for the debts and obligations of the corporation; thus, creditors will not come knocking at the door of a shareholder to pay debts of the corporation. Conversely, in a partnership or sole proprietorship the owner's personal assets may be used to pay debts of the business.

Other advantages of corporations include:

•Incorporating can help to establish credibility for new businesses with potential customers, employees, vendors, and partners.

•A corporation's life is not dependent upon its members. It possesses the feature of unlimited life. If an owner dies or wishes to sell his or her interest, the corporation will continue to exist and do business.

•Retirement funds and qualified retirement plans (like 401k) may be set up more easily with a corporation.

•Ownership of a standard or C corporation is easily transferable.

•Capital can be raised more easily through the sale of stock.

Corporations are not without disadvantages, however. The primary disadvantage to a corporation is double taxation. Profits of a corporation are taxed twice when the profits are distributed to shareholders as dividends. They are taxed first as income to the corporation, then as income to the shareholder. For example, if the corporation has $100,000 in profit, it would pay corporate income tax on that profit. If it distributes part of all of the profit to shareholders as dividends, the shareholders then pay individual income tax on the amount of their dividend distribution. All reasonable business expenses, such as salaries, are deductions against corporate income and can minimize the double tax. Further, the double tax can be eliminated by making the S corporation election with the Internal Revenue Service (IRS).

Other disadvantages of corporations include:

•There is a certain level of complexity and expense of forming a corporation, such as the necessity of filing formation documents with the state and paying the necessary state filing fees.

•Corporations have fairly extensive ongoing record keeping requirements.

•Corporations that transact business in states other than their state of formation may be required to qualify to transact business in those other states.

Both the limited liability company (LLC) and S corporation also provide the limited liability advantage to the owners/shareholders of the company, without the potential disadvantage of double taxation. These other business structures also have their own advantages and disadvantages. If limiting your personal liability is an important goal for you as you start or operate your business, it is a good idea to learn about all three structures when deciding what form your business should take.

About the Information Provider
John Leslie, a certified Quickbooks Pro Advisor, has 20 years of experience in the tax field. Mr. Leslie is a member of the Lakeside Chamber of Commerce, has been involved in the San Diego business community since 1986 and has lived in the area for over 40 years. His strong ties to the community have shaped the client-business philosophy for which IRSTAXHELP.COM is known.


Anonymous said...

Incorporating a business have the advantages which you said above. It also have disadvantages such as double taxation and the need of a professional for legal assistance in taxation and legal matters. What do you think?

Carl Starrett said...

Double taxation can be avoided in full or in part with the proper tax planning. For example, becoming an S corporation is a popular way to avoid the issue of double taxation. As for the cost of legal assistance, that is nearly always far outweighed by the tax savings of incorporating. For example, I offer a retainer that includes free phone calls that costs less than $85 per month while my client save thousands in taxes. In my opinion, nobody should ever do business as a sole proprietor. Even without the personal asset protection, the tax savings alone is often enough to justify the cost of incorporation.