A question that I am frequently asked by those either starting or growing a business is: “Should I incorporate?” The next question is: “What is the difference between the different kinds of corporations?”
Before I get started I want to point out that I am not any kind of tax expert and although I believe this information to be accurate, you should always check with a CPA or tax expert before taking any of my advice.
There are two different kinds of corporations that you could sign up as with your state corporation commission — a regular corporation and a Limited Liability Corporation (LLC). These are state specific entities. There is also an S Corporation which is a federal tax entity.
When it comes time to file your income taxes, if you are a regular C-Corp, the corporation files a tax form and pays taxes on its income and then you pay taxes on income that you earned from the corporation. By paying as a corporation and then paying taxes on your income from the corporation, you are in effect paying double taxes.
The way to get around that is to file taxes as an S-Corp. The corporation’s income is passed through the corporation (without paying the taxes) and then filed as income with your personal taxes. An S-Corp is not automatic, however. You have to file the paperwork with the IRS requesting to be considered an S-Corp once your state incorporation is complete.
A Limited Liability Corporation (LLC) offers all the tax and liability benefits of a corporation but are usually easier to set up and operate. In my state, a corporation has to file a corporate tax form (with a fee) annually while an LLC does not. In some states, filing may be more complicated but in my state, the Corporation Commission makes it easy for a person to file the necessary paperwork without an attorney.
You can also request S Corp status for your LLC. Your CPA can advise you on the pros and cons. You’ll have to make a special election with the IRS to have the LLC taxed as an S corp using Form 2553. And you must file it before the first two months and fifteen days of the beginning of the tax year in which the election is to take effect.
The LLC remains a limited liability company from a legal standpoint, but for tax purposes it’s treated as an S corp. Be sure to contact your state’s income tax agency where you will file the election form to learn about tax requirements.
What I see as the primary reason for running your business through a corporation — whether it be a regular one or an LLC — is liability protection. There are also tax benefits which you should discuss with your CPA early in the year.
Running your business 100% through a corporation can shield your personal assets from lawsuits related to your business. A corporation is considered a separate “person” under the law. So if someone sues you for something related to your business, they have to sue the corporation as long as you run it properly.
But you MUST be careful not to mix anything personal with business. Never use your corporate bank accounts or credit cards for personal use. If you make any substantial changes to how you operate your business, keep corporate minutes. The lawyer for anyone trying to sue you will try to “pierce the corporate veil.” They will subpoena copies of your bank and credit card records and look for any personal use. If they can find any, they can then request to sue you personally instead of suing the corporation.
These are only the basics but should give you a place to get started. In my state, even a business with only one owner/shareholder can become a corporation. So size and profits make no difference.
If you are operating as a sole proprietor or partnership, January is a good month to talk to your tax person and see how becoming a corporation could benefit you. And remember if you are already an LLC wondering if S-Corp designation by the IRS would be helpful for you, you only have a short window of the first two months and fifteen days of the beginning of the tax year in which the election is to take effect. Otherwise, you’ll have to wait until 2017.