Are you in business? Are you thinking about starting a business? If so, you should consider whether a corporation is right for you. Let’s go over what an incorporated business means for you and your tax bill.
Every business has a legal form. One of the most common legal forms for businesses is the corporation.
So, what’s a corporation? A corporation is an independent legal entity owned by its shareholders. Most people use corporations to own and operate for-profit businesses. But there are also nonprofit corporations used to operating charities.
A corporation has a legal existence distinct from its owners. In fact, it is its own legal “person.” That means it can hold title to property, sue and get sued, have bank accounts, borrow money, hire employees, and do anything else in the business world that a human being can do.
The word “corporation” tends to conjure up large businesses like Microsoft. But many corporations are quite small. Indeed, many corporations have only one shareholder.
Forming a corporation is a simple matter. As such, many people do it themselves. Or you can use a low-cost incorporation service.
A corporation begins its legal life by filing a short document called “articles of incorporation” with a state government. You can form your corporation in any of the 50 states. But it is usually wise to base your corporation in the same state as the main office. In many states, the Secretary of State is the official in charge of corporation filings.
Articles of incorporation are simple and easy to create. Many states have online forms you can fill out. You only need to provide necessary information about your corporation. The basics include the business name, contact information, and the name and address of a “registered agent.” A registered agent is a person or company that will accept legal papers and other filings for the corporation.
In addition to articles, your corporation should have bylaws. This extensive document describes the corporation’s governing rules.
Before you start doing business, you must hold an initial meeting of your board of directors. You must also “capitalize” your corporation—issue stock in return for money, property, or services provided to the corporation.
Fortunately, small corporations usually don’t have to worry about federal and state securities laws. These require corporations to register with the federal Securities and Exchange Commission or its state equivalent before offering their shares for sale. Small corporations usually get exempted from such registration.
In theory, every corporation consists of three groups of people:
In the case of a small business corporation, these three groups often boil down to the same person. A single person can direct and run the corporation and own all the corporate stock. So, if you want to incorporate your one-person business, you don’t have to go out and recruit a board of directors or officers.
Owners of small businesses that incorporate ordinarily work as employees of the corporation, in addition to fulfilling their other corporate roles.
Three big advantages come from incorporating your business:
A corporation provides its owners with limited liability. Mean shareholders are not personally liable for corporate debts or lawsuits against the corporation.
Creditors or people who file lawsuits against your corporation can collect against its assets, like your corporate bank account. But, they can’t get their hands on your personal assets like your bank accounts, private car, or home.
Yet, always keep in mind that there can be limits on the limited liability provided by a corporation. For example, creditors may require you to personally guarantee corporate debts before extending credit.
Moreover, you are always personally liable for your wrongdoing. For example, a corporation won’t protect you if an injury occurs due to your personal malpractice or negligence.
You can save on taxes by incorporating your business. But not always. When it comes to taxes, there are two types of corporations:
Each type of corporation has benefits and drawbacks. You can start out as an S corporation and switch to a C corporation later, or vice versa.
When you form a corporation, it automatically becomes a C corporation. A C corporation separate from its owners for tax purposes. C corporations must pay income taxes on their net income and file their tax returns with the IRS.
As a result of the tax reform law that took effect in 2018, all C corporation profits get taxed at a flat 21% rate. This lower rate is better than individual income tax rates at higher income levels. Thus, you can save on income tax with a C corporation. But money you take out of your business as a shareholder dividend gets taxed twice. So the benefit of the lower tax rate can be illusory.
In addition, because a C corporation is a separate tax-paying entity, it may provide its employee-shareholders with tax-free fringe benefits such as health insurance. It can deduct the entire cost of the perks from the corporation’s income as a business expense. No other form of business entity can do this.
C corporations can be better for successful businesses with substantial profits. Yet, a C corporation is not the right choice if you expect your business to lose money in its first few years of operation. This is because you can’t deduct losses from any other income you have, such as salary income.
You always have the option of having your corporation taxed as an S corporation instead of a C corporation by filing an election with the IRS.
An S corporation is not a separate taxpaying entity. Instead, corporate income or losses get passed through directly to the shareholders.
The shareholders must divide the taxable profit according to their shares of stock ownership and report that income on their individual tax returns. They pay income tax on these profits at their individual tax rates.
An S corporation normally pays no taxes, but must file an information return with the IRS showing how much the business earned or lost and indicating each shareholder’s portion of the corporate income or loss.
S corporations are the most popular for one-person businesses, primarily because they can result in reduced Social Security and Medicare taxes.
Investors often prefer to invest in corporations and receive stock ownership in return. This is particularly true if you’re seeking investment from venture capitalists.
Incorporating is also necessary if you ever want to attract investors through a public stock offering. Also, issuing corporate stock options is an excellent way to motivate and keep key employees.
Creating and operating a corporation takes more money, time, and trouble than other types of business ownership. For example:
Incorporating could also result in a higher tax burden. For one thing, your corporation may have to pay state corporation taxes in addition to federal taxes.
If you’re the owner of a C corporation, there’s also the problem of “double taxation.” Any direct payment of your corporation’s profits to you is a dividend and taxed twice. First, the corporation will pay corporate income tax on the profit at corporate rates on its return. Then, you’ll pay personal income tax on what you receive from the corporation. You can avoid this by forming an S corporation.
Finally, you automatically become an employee of your corporation if you work in the business. This situation exists even if you’re the only shareholder and are not subject to the direction and control of anybody else.
In effect, you wear two hats: you’re both an owner and an employee of the corporation. Withholding Social Security and Medicare taxes apply to any employee salary your corporation pays you and the money paid to the IRS just as for any employee.
You’re also an employee for unemployment insurance, workers’ compensation, or other legal purposes. The added expense can make a corporation more costly to operate than other legal forms.