When and why should you incorporate your small business?
Should you incorporate your small business? Whether you run a side hustle or are a full-time entrepreneur, this guide can help you decide.
To incorporate or not to incorporate
Whether you have a successful side hustle or are a full-time entrepreneur, business structures and liability can get confusing fast - and incorporation is no exception.
Incorporation means establishing a business that is legally separate from its owners. Here are the three most common business structures for small businesses:
- Sole proprietorship: The default for anyone selling goods or services. You have personal liability, meaning that you risk losing your personal assets if you run into business debts or liabilities.
- Limited liability company (LLC): A separate legal entity for your business. That’s where the “limited liability” piece comes in: you’re not personally liable if your business runs into debt or lawsuits.
- Corporation: A business entity formed by filing Articles of Incorporation. Incorporating protects business owners’ personal assets from any corporate liability.
As an LLC or corporation, you can register to be taxed as an S corporation to avoid double taxation.
Here are three signs it’s time to incorporate your business:
- You’re bringing in over $60K in income and are ready for the tax advantages of filing as a corporation.
- You want to make your business more official. Investors and clients alike view corporations as more professional and credible than sole proprietorships or 1099 contractors.
- You need access to loans or credit - or might in the future. Starting a business bank account and building your credit is key to keeping your finances organized and being approved for a loan or credit when you need it.
As always, there’s no one-size-fits-all approach to structuring your business. Working with a small business CPA and attorney is the best way to ensure you’re making choices that set you and your business up for success.
When you start your own business, there’s no shortage of business advice out there. It seems like everyone has a different opinion on how you should do things, from your branding to your business structure and everything in between.
“You should incorporate your business ASAP,” one person tells you. “Stick with an LLC, it’s much simpler,” another chimes in.
Whether you have an online side hustle or are a full-time entrepreneur, there aren’t enough hours in the day to run your business and become fluent in corporate tax and legal jargon.
That’s why we put together this guide on when to incorporate your business. We’ll also cover what it means to incorporate a business, the different types of business structures for small businesses, and how incorporating affects your taxes.
One quick note before we jump in: I am not a lawyer or accountant, and this is not legal advice. We highly recommend consulting with a small business attorney and CPA when choosing a business structure.
What does it mean to incorporate a business?
At its most basic, incorporation means establishing a business that is legally separate from its owners.
When you incorporate your business, you turn your sole proprietorship or LLC into a company that is formally recognized by your state of incorporation. In other words, your business becomes a corporation.
While LLCs are technically separate entities from their owners, they aren’t considered corporations. We’ll dive deeper into what defines an LLC in a bit.
Keep in mind that your business doesn’t have to be incorporated to be legally considered a business.
In the U.S., if your business brings in more than $400 a year , you must report that side income on your tax returns — even if that business is a side hustle. (And if you’re bringing in significant income, you may need to pay quarterly estimated taxes , too.)
Incorporating a business can be a complex and expensive process, especially if you’re new to entrepreneurship. So, before you decide whether it’s time to incorporate your business, let’s go through the different types of business structures you can choose from.
Sole proprietorship vs. LLC vs. corporation
One of the most important questions to ask before starting a business is, “What type of business should I start?”
Each business structure has different financial and tax implications, which you can learn more about in our guide to the legal and tax requirements for starting a small business .
For now, let’s talk about three of the most popular legal structures for small businesses: sole proprietorships, LLCs, and corporations.
Sole proprietorships vs. LLCs
Sole proprietorships make up 73% of all businesses in the U.S., accounting for 23 million small business owners. Any new business selling goods or services is a sole proprietorship by default.
As the sole proprietor, you have personal liability, meaning that you risk losing your personal assets if you run into business debts, losses, or liabilities. You also have to pay personal income tax on profits earned.
When you organize your business as a limited liability company (LLC), you create a separate legal entity for your business. That’s where the “limited liability” piece comes in: you’re not personally liable if your business runs into debt or lawsuits.
“If a client were to sue me, that protection would make it difficult for the other party to seize my personal assets — for example, my family’s personal savings account. Or our house.
Other than that liability protection, the credibility that comes with an LLC, and using a new FEIN instead of my social security number, not a whole lot has changed on the tax front. Revenues still ‘pass through’ Wunderbar LLC to me as an individual.”
To form an LLC, you need to register your business name and file a document called the Articles of Organization with a state or local government agency. Once your articles of organization are approved, you officially have a legally registered business entity.
Corporations (S corps vs. C corps)
Like an LLC, a corporation’s structure protects business owners’ personal assets from any corporate liability.
A corporation is formed by filing Articles of Incorporation with the Secretary of State.
Corporations also need a Board of Directors to oversee the corporate business and agree on bylaws — even if the corporation is made up of just one person .
Yep, as a solopreneur , you can be the only director on your board. You still have to submit annual meeting minutes to your state agency.
C corporations are subject to corporate tax rates, which means that if you’re self-employed, you run into double taxation. Double taxation means you pay taxes twice (personally and as a business) on the same income source.
To avoid double taxation, almost every small business that incorporates does so as a subchapter corporation, or S corp. S corporations make up 76.6% of all corporations in the U.S.
An S corporation is a tax classification .
The IRS requirements to be taxed as an S corp include:
Be a domestic corporation
Have only allowable shareholders
Have no more than 100 shareholders
Have only one class of stock
Both LLCs and C corps can register to be taxed as an S corp. S corps don’t pay dividends. Instead, tax burdens and income are passed through to the business owners.
Classifying your LLC as an S corporation offers the best of both worlds for small businesses. You get all of the benefits of an incorporated business without double taxation.
Our next section is all about those benefits. Keep reading to learn when and why you should incorporate your business.
When (and why) should you incorporate your business?
Here are three signs you’re ready to reap the benefits of incorporating your business.
1. You’re bringing in over $60K in annual profits
Incorporating your business changes the way you pay taxes, so it makes sense that your corporate income plays a big role here. One of the main signs that it’s time to incorporate your business is hitting a certain profit threshold.
Business lawyer Keren de Zwart recommends:
“If your business is netting at least $60K in profits, that’s usually a good time to formalize into an LLC or corporation because the tax benefits can really start to be utilized then.
If you have high personal net worth and/or significant personal assets, it may make sense to form an entity earlier on to protect yourself.”
If you’re looking for a point of reference, the average small business with no employees brings in annual revenue of $46,978. That said, more and more one-person companies are crossing the six-figure and even one million dollar revenue threshold.
According to Payscale , the average small business owner’s salary in 2021 was $64,977.
There’s no hard and fast rule here, but if you predict that your business will be bringing in more than $60K in profits, talk to an accountant about the tax benefits of incorporating your business.
2. You want to make things more official
Incorporating your business can build your credibility with potential customers, investors, and peers.
One reason he chose to incorporate was to improve his clients’ perception of his business: “1099 contractors are often perceived as cheap commodity laborers, not valuable business partners,” he explained .
If you’re a startup planning to pursue capital funding or investors, incorporating your business can also help you attract investors. Investors and venture capitalists are unlikely to invest in an unincorporated business over one that can issue shares of stock.
Incorporating your business can also help you protect your brand. When you incorporate your business, you need to register your business name with the state. Once registered, no one else in the state can use your business name.
One more thing on the topic of making things official: When you incorporate your business, you need to designate a registered agent.
A registered agent is someone appointed to accept service of process and official mail on your business’s behalf. As a small business owner, you can be your own registered agent or use a registered agent service.
3. You need access to loans or credit (or might in the future)
When you incorporate your business, it becomes its own entity with its own credit. Just like personal credit, you can build your business credit over time.
When your business has good credit, you can apply for business loans or open a business credit card.
First and foremost, make sure you have a business bank account. 27% of small business owners don’t have a separate bank account for their business — and that’s a risky move.
Separating your business finances from your personal ones is vital for lowering your liability (and keeping things organized). If you take out a business loan, you’re not personally liable for paying it back.
Plus, 70% of small business owners who don’t have a business bank account get rejected for loans. Your business bank account can also help you show your business’s cash flow to a potential lender if you need to apply for a loan or credit card.
You might not need a business loan right now, but credit takes time to build. Why not start now?
By now, you hopefully have a solid idea of what it means to incorporate your business and whether that’s a step you’re ready to take. To learn more and begin the incorporation process, we highly recommend working with a small business attorney and accountant.
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