There is no doubt that owning a small business comes with a lot of benefits and flexibility. You get to do things your own way, chase your dreams as far as they can go, and hopefully, you will earn a decent living out of it. Most small business owners focus on expanding their trade and finding new ways to grow, which is great all in all!
But what happens the minute you outgrow the “small” business suit? Is it safe to stay there, while all the “big things” await you on the next level? This is where you need to stop and consider your choices because growing means so much more than money flowing into your business.
The next level is called “incorporating” your business if you are a sole proprietor, which essentially means becoming a corporation with respect to accounting and liability. The majority of tax experts will agree on this with us; there are several incorporation advantages for your business, should you decide to do it.
So, what are the benefits of incorporating a small business? In this article, we are going to guide you through the basic benefits of incorporating yourself and mention some of the disadvantages, as well. Let’s dive in!
First things, first! What does incorporation mean?
Incorporating your freelancing business means changing its business structure into something more corporate-y, in order to enjoy tax benefits and reduce your personal assets’ liability. The benefits of incorporating a small business are many; including deductible life insurance benefits, retirement plans, and travel expenses deductions.
This process enables you to transform from a “natural” person into a corporate entity, recognized under the law. This new legal entity can take many forms depending on the registration fee you need to pay, the actual business internal structure (partnership, cooperative, LLC, etc), and the bureaucratic procedure required. It all depends on you and how you visualize your business’s future.
Every state in the United States has different regulations and setup fees regarding the incorporation process, so you want to visit your state’s website for more information. According to the business structure, you will choose your company’s name must have the respective legal ending like “Inc.”, “Corp”, “Ltd” and so on, but we won’t become too technical about that in this article.
The next question that mind-pop into your mind probably is:
When is the right time to incorporate your business?
The number one reason to incorporate your business is to protect your personal assets. When you are a sole proprietor, your assets are on the line in case things go awry. This is especially true if you have taken a small business loan. Creditors will be after your personal assets as soon as you are unable to fulfill your obligations, regardless of the reason or your previous collaboration.
Apart from that awful scenario, incorporating your small business could be beneficial if the business is doing well and you need to share the liability with a partner. This way, they can buy a number of shares and help expand your business even more. So, when your business is starting to grow out of control, it is best to consider incorporating it.
Consequently, increased revenue means higher taxation in the case of a freelancer. This is because, apart from the freelancer’s own personal tax return, there is a tax applied on the profits, as well! You realize this is a heavy load for one, even two people to bear.
So, in order to decide whether it’s a correct decision, you need to take a look at what are the advantages and disadvantages of incorporation. Let’s go!
Advantages of incorporating your business
- Tax benefits: Expenses that are only partially deductible for a sole proprietorship can be fully deductible for an incorporated business.
- Protected personal property: Freelancing means having your own money on the line, while corporations limit the liability of the owners. So, in case a customer sues your company, wins and the corporation has to compensate them, if the company’s assets are not sufficient, then you don’t have to cover the remainder with your own money.
- Accounting accuracy: Sole proprietors use single-entry accounting to log their sales and purchases, while corporations use double-entry books. They keep their financial transactions in two ledgers – one for credits and one for debits. This leads to limited bookkeeping errors and ultimately fewer chances of IRS auditing since double-entry accounting raises fewer red flags that require review.
- Enhanced credibility: To the majority of customers/collaborators, corporations sound more credible and sophisticated.
- Shared liability: When other people join your business, you get to share profits but you also share the risk of running it.
- Easily transferable ownership: corporations are way more flexible than sole proprietorships because business owners don’t own company property directly but via stock shares. This makes things a lot easier when they need to transfer those shares to a partner or a family member.
- Lending advantage: Unincorporated small business owners are less likely to be approved for bank loans, due to their limited capacity of ensuring pay-off. A corporation, on the other hand, is able to present solid financial statements which reassure creditors.
Disadvantages of incorporation
- More paperwork: Incorporating your business requires a ton of paperwork and tedious bureaucratic procedures. Each state has a different set of requirements, so you need to do your homework and probably consult with a tax expert before moving on.
- Setup fees: Depending on the state and the business structure you choose to go with, incorporating your business may cost you from $25 or up to $1,000. Freelancing, on the other hand, requires no fees.
- Double taxation is possible: In some cases, shareholders of small businesses may need to pay taxes twice. First, there is taxation on the corporation’s profits and then the shareholders must pay taxes based on their share, as a personal income.
However, the double taxation problem can be avoided by selecting the “S” business structure to incorporate yourself. The next step is to weigh your options and decide whether the pros outweigh the cons for your case.
In this article, we explored the advantages and disadvantages of incorporating of a company versus running a sole proprietorship. However, in the next article, we are going to analyze the various business structures your small business can transform into, in order to thrive and become more flexible. Stay tuned!