Starting a new business is exciting, but tackling some of the financial and legal questions that come with the territory can be the hardest part of the journey. Case in point: incorporation. What does incorporating your business entail, and is it something you have to do? If so, how do you pick the correct entity for your business? While deciding on the best course of action can be tricky (and is best done with the help of a lawyer or tax professional by your side), having the answers to these common questions is a great place to start.
What does it mean to incorporate your business?
Incorporation can take several forms. Still, they all entail the same thing: setting up your business as an independent legal entity recognized by your state or the federal government. It’s a way to separate yourself and your personal assets from your business and any business-related taxes, debt payments, credit, and other financial obligations.
By default, new businesses are regarded as sole proprietorships. This business entity has no legal separation from its owner in the eyes of the state and requires the owner to pay self-employment taxes (15.3%) based on income. While this is the easiest type of business to set up—a sole proprietorship requires no formal process—it does come with a high degree of financial liability for the business owner. Incorporation helps reduce that liability and minimize personal risk for business owners.
Note: Incorporating your business is different from registering your business, which simply establishes the existence of your business so you can operate legally in your state. Registering your business does not establish it as a legal entity.
Should you incorporate your business?
Every business is different, and incorporation might not always be the right way to go. There are many pros to incorporating your business, including protecting your personal assets, reaping tax benefits, and establishing a solid brand reputation. However, incorporation isn’t without its drawbacks, such as high cost and, in some cases, double taxation.
Figuring out whether incorporation is the right choice for you comes down to various factors, including what your goals are as a business as well as the nature of your business overall. Are you at the stage where you’re looking to raise money? Incorporating could make it easier to secure financing and capital from investors. Are you a solopreneur who’s just starting? It may not be worth it to spend time and money incorporating at this stage in your business journey, and you might prefer to operate as a sole proprietorship until you’re more established as a business. Yet, that may change if you’re a solopreneur who sells consumable products, for example, in which case it doesn’t hurt to have an added layer of legal protection given the higher-risk industry.
If you assess your business goals and decide that incorporation makes sense at your current stage, the next step is to select the correct legal entity for your business.
How can you decide on the right entity for your business?
Determining the ideal legal entity for your business can be complicated. Again, working with an attorney, tax professional, or accountant is the best way to work through options and plan the right course of action for your business. That said, it helps to have a clear understanding of what different legal entities would entail for your business as it ensures that you go into any conversation or consultation with as much information as possible.
Here are the most common legal entities to choose from when incorporating your business and some benefits and drawbacks of each:
LLC
A limited liability company (LLC) is a legal business entity between sole proprietorship and corporations, where a business owner has limited personal liability. An LLC can be formed either as a single-member LLC with a sole owner or a multi-member LLC with multiple owners.
Perhaps the most significant benefit of the LLC is the limited liability it affords business owners. As the owner of an LLC, your personal assets are protected and cannot be held as collateral against any debts or financial obligations incurred on behalf of the business.
Another major benefit is flexibility, especially when it comes to choosing preferred tax treatment. This is important because while an LLC is a pass-through entity that allows you to bypass double taxation, it does not eliminate the need to pay self-employment tax. However, business owners can choose how they want their business to be taxed as an LLC, which means it’s possible to be taxed as a partnership, a corporation, or, in the case of a single-owner LLC, a sole proprietorship.
C Corporation
A C corporation, or C corp, is a business entity that is legally separate from its owners, independently taxable, and can sell stock to shareholders in exchange for partial ownership of the company. This makes the C corp structure especially appealing to startups or businesses at a stage where they’re looking to raise capital or go public.
This type of entity offers the most robust protection against personal liability (good news if your business is in a high-risk industry like health or financial services) but comes with one major drawback: double taxation. This means that C corps are taxed twice, once at the corporate level and again on any dividends distributed to shareholders. If the owner of a C corp gets paid a salary, that would be taxed separately from the corporation. That said, one of the tax benefits of a C corp is that net operating losses can offset future taxable income.
Note: The Tax Cuts and Jobs Act of 2017 established a single corporate tax rate of 21%, which is a significant improvement from earlier years, where those rates could reach as high as 35%.
S Corporation
An S corporation, or S corp, is a business entity similar to a C corp in that it offers limited liability protection and is governed by the same state laws that impact any corporation. The difference lies in factors like shareholder limitations (S corps can have a maximum of 100 shareholders who must be U.S. citizens or residents) and tax treatment.
An S corp is a pass-through entity (like a sole proprietorship) whereby a company avoids double taxation by passing all business income through to its owner, who then reports it on their personal tax return.
Unlike a sole proprietorship, S corps allow owners to pay income tax only on business income instead of paying self-employment tax. That said, S corps do require owners to pay themselves a reasonable salary as part of this business structure, and that salary will be subject to FICA taxes (7.65%) but will also be tax-deductible for your business.
While there are several tax benefits to operating as an S corp, there’s also a slightly higher level of risk since the IRS tends to keep a closer eye on this type of corporation given the potential for abuse.
What’s next for your business?
Incorporation won’t be right for everyone. Whether it’s your unique business goals or simply a matter of timing, there are plenty of factors that come into play when making the decision to establish your business as a legal standalone entity. That said, when the timing is right and you feel confident that incorporation makes sense for you, there’s no doubt that the increased credibility, limited liability, ability to build up business credit, and increased access to funds and financing will feel well worth the effort as you grow your business.
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