If you have been running your business as a sole proprietor or are planning to be self-employed, you should probably give the idea of incorporating your business serious thought. Since we are talking about incorporation from the taxation point of view, you should know that it has its own set of implications. Corporations have to abide to a greater number of rules and policies at state, as well as the federal level. The exercise of incorporation of business is certainly time-consuming and expensive; but it can prove fruitful in the long run in the right cases. John Gregory, tax practitioner and founder of 1040Return.com, offers tips to help determine if incorporating your business is the best step for you.
“Usually, the self-employed people or the sole-proprietors are advised to incorporate as an S corporation,” says John Gregory, tax practitioner and founder of 1040Return.com. “The important thing is to find out whether or not incorporation will suit your small business.”
Here are tips to help you determine if incorporation is indeed the best choice for your business:
Protects the Personal Finances of the Owners. The term ‘corporation’ is derived from ‘corpus,’ which means ‘body’ in Latin. Therefore, a corporation is considered as artificially created legal person, which means it is a stand-alone entity separate from its owners. The owners have a limited liability. If someone sues your business, they can only go after the corporation’s assets, thus protecting your personal assets from the business’ liability.
Helps Circumvent Double Taxation. If you are looking for a solution to avoid double taxation, incorporating an S corporation is the best way out. All the profit that your S corporation makes flows to your personal tax return and will be subject to personal tax rate only. Filing as a C corporation will mean paying double the taxes, because they are subject to corporate tax rates. Besides, any dividend that you receive from a C corporation will be reflected in your personal tax return and subject to personal tax rate. This is called double taxation.
Decreased Odds of Being Audited. The risk of being audited by the IRS falls considerably when you file as an S corporation. Statistics for the year 2012 suggest that individuals who file a Schedule C had increased incidences of being audited; 7 percent as against 1 percent in case of S corporations.
Enhanced Credibility. Incorporation certainly enhances a business’ credibility in the eyes of the lenders. Non-incorporated businesses often face difficulty in raising loans and getting a leeway from the creditors and suppliers. If your business depends heavily on assistance from bank and creditors, regarding the working-capital requirement, short-term loans and longer credit period, going for incorporation will be a wise move.
The Aspect of Foreign Ownership. This is an important point to be taken into consideration before you file for incorporation. Businesses having foreign ownership are not allowed to incorporate as an S Corporation. Businesses incorporated as S Corporation are purely domestic companies.
Easy Transfer of Ownership. The ownership or the interest in an S corporation can be easily transferred from one person to another as against the in case of limited liability companies and partnerships, without causing any unfavorable tax consequences.
Helps Portray Tax-Favorable Scenario. The S corporation allows its owners to be its employees as well and draw salaries. The IRS has stringent rules stating that you have to take W-2 wages. The wages should be comparable to those prevalent in your industry for the services you render to the corporation. However, there is trade-off. The distributions you receive do cut back the amount you need to pay in Social Security and Medicare taxes, but you will receive a smaller amount from your Social Security at the time of retirement. If you wisely dispense the corporation’s income into wage-payments and distributions, you could avoid very large tax bites on your personal income.
Stock Ownership Constraints. The S corporation is allowed to have only one class of stock, which can be a combination of voting and non-voting stocks. The law prescribes that there should be no more than 100 shareholders. As mentioned earlier, ownership by foreign entities is prohibited. Besides, there are certain types of trusts that are forbidden to have an ownership in the stocks of S corporation. As rigid as the rules may seem, raising capital by issuing stocks is equally simple for an S corporation. You can issue up to 51 percent of the stocks in return of capital investment. Since you would issue the non-voting stock for raising the capital and retain the voting stock, you would continue to retain control over your company.
“There are pros and cons of incorporating your small business.” says Gregory. “Ideally, you choose the right option from the taxation point of view.”
For more information, visit www.1040Return.com.
Current Issue - May 2024