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Should I incorporate?

You can operate your business as a sole proprietor, like 70% of American companies. However, if business turns great and you start to earn a lot of cash, then it would be wise to incorporate it as a method of reducing your taxes and protecting profits.

You may be implementing a growth strategy that requires you to hire additional investors, or perhaps implementing your exit strategy, with a plan to sell your business, perhaps to employees through an Employee Stock Option Plan ( ESOP). Either scenario may prompt your accountant or business attorney to recommend that you establish a separate legal entity and the preferred strategy could be incorporation.

What does that mean in practical terms? For a Solopreneur consultant or small business owner, incorporation generally means establishing an S Corporation. A Limited Liability Company (LLC) is another frequently used legal business entity and there are certain similarities between the two.

Both LLCs and S corporations provide business owners with a degree of protection against lawsuits and creditors. However, if negligence is involved, the “corporate veil” of protection will be pierced and the owners will be held liable for damages.

Second, there are certain similarities in the way taxes are handled. LLCs and S Corporations, unlike the more common C Corporations, allow a “roll-over” of business profit or loss to the owner’s (S Corporation shareholders) Form 1040 personal tax based on the ownership interest. property. There are no separate (double) taxes, as with C corporations. Both S Corporation and LLC owners can deduct pre-tax business expenses such as advertising, professional services, travel, and so on. S Corp owners will file Form 1040 Schedule E and Form 1120S in addition to the usual state and federal tax forms.

However, there are a couple of differences that affect the treatment of taxes. Unlike the LLC and like the C Corporation, the owners of the S Corporation pay themselves a salary (which should be considered reasonable by industry and business income standards) and receive dividends (distributions) from the companies. additional earnings earned. Dividends are taxed at a lower rate than salary payment and that is one of the reasons why S Corporation’s tax rates may be lower.

Another difference relates to taxes on self-employment. Says Diane Kennedy, a public accountant based in Phoenix, AZ and author of “Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax” (2001), “If you have a Subchapter S Corporation and you put yourself on the payroll As a W-2 employee, by withholding tax from each paycheck as you withdraw money from the corporation, you can often save a significant amount of money in self-employment taxes. ” Sole proprietors and LLC owners must pay self-employment taxes.

Owners can sell, transfer or give away their shares, something that LLC owners cannot do. There can be no more than 100 shareholders / owners of S Corporation, but family members who own shares are treated as a single shareholder when counting. Other corporations, subchapter C or S, continue in perpetuity unless formally dissolved. Death does not automatically dissolve a corporation, while LLCs end if an owner retires, resigns, dies, or goes bankrupt, but they can be reformed if desired.

On the downside, S corporations have stricter guidelines than LLCs. Owners must be US citizens or reside in the US There can only be one class of shares and depending on the state in which it is incorporated, there may be additional state taxes. Businesses that earn 25% or more of gross income from passive income (for example, rental income) and those that earn 95% or more of gross income from exports cannot form an S Corporation.

S corporation owners must also hold annual meetings of directors and shareholders and take minutes. Additionally, owners must strictly separate their personal and corporate bank accounts. Failure to comply with all requirements can result in loss of S Corporation status and the IRS is seeking.

So which legal entity is best for your organization? Throughout the life of your business, it is wise to contemplate your plans for the future in terms of revenue, growth, exit strategy, and taxes, and institute the legal structure that will improve your position.

Thank you for reading,


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