When and How to Incorporate

If you've been in business for a while as a sole proprietor, you may be wondering whether it would be a good idea to incorporate. To help you make that decision, we'll give you some of the reasons why people incorporate, explain how a corporation is structured and tell you how your tax treatment will change if you become a corporation.

Reasons for Incorporating

Picture this: You started a small landscaping business a few years ago as a sole proprietorship with three employees. Demand was so great for your services that you kept hiring more people and taking on debt to purchase more equipment, and the number of customers has soared. But lately you've started to wonder: What happens if business slows and you can't pay back all the debt? What if a disgruntled employee or unhappy customer sues you? As a sole proprietor you're personally liable for any bad debts and legal judgments against your business, meaning that your home and other personal assets are at risk.

As a small business grows, concern about personal liability is a key reason why its owner may decide to form a corporation. When you incorporate, you're creating a completely separate legal entity, one that shoulders the liability burden you had been carrying yourself (or, if you are a partnership, the burden you and the other partners were carrying). As a shareholder of your corporation, your losses would be limited to your investment in the company.

Forming a corporation also allows you to:

• Reward and retain key staff by giving workers a piece of the business.
• Have more options for raising funds. Instead of going into more debt, you can attract equity investors.
• Shift tax liability away from you to the corporate entity.

But you'll have to weigh some disadvantages as well:

• It takes more time and money to incorporate than to form other types of businesses.
• Corporations are subject to more regulation at both the federal and state level.
• The management structure of a corporation is more rigid, giving you, as the owner, less flexibility to run things as you see fit.

Corporate Structure

Each corporation has a three-tiered structure, consisting of:

• Shareholders: As company owners, they are the linchpins of the corporation. They have the power to select and remove directors, amend bylaws, approve the sale of assets, and dissolve the corporation. You don't necessarily have to have a lot of shareholders. In fact, most states permit one person to hold 100% of the corporation's stock.
• Directors: They act on behalf of the stockholders, managing the company, making major decisions about the firm's direction and electing company officers. Most states allow corporations to have a single director, but some require a minimum of three.
• Officers: In most states, corporations must have at least a president, secretary and treasurer to handle day-to-day running of the business, but many states also allow one person to hold all three positions.

Steps to Becoming a Corporation

To get your corporation started, you'll need to draw up articles of incorporation in the state where your business is headquartered. The articles declare basic facts about the company, including its name, purpose and the number of shares authorized. You file this document with the appropriate state office (usually the secretary of state or department of commerce) and pay a filing fee, which can run several hundred dollars. You may want to hire an attorney to handle the process. The state will process your filing and send you a certificate of incorporation.

With your certificate in hand, you can take the next steps, including appointing directors and holding your first directors' meeting. You'll need to draw up bylaws, which detail the rights of the shareholders, directors and officers. You also must issue stock. It doesn't have to be widely held, but must be distributed to everyone who is an owner of the corporation.

Tax Issues for Corporations

Once you have incorporated, you'll notice a big difference in how your company is treated for tax purposes. You'll no longer file Schedule C and report your net profit or loss on your 1040. Instead, the corporation files a business tax return, Form 1120, and pays tax on its corporate profits. If you're a small corporation, you may be eligible to file the short form, 1120-A. To do so, you must meet a long list of eligibility requirements, but the key point is that your company's gross receipts, total income and assets each must be less than $500,000.

Many owners of new, small corporations may get a pleasant surprise at tax time. Sole proprietors can't deduct any salaries they pay themselves, but after incorporating they become employees, and their compensation can be written off by the corporate entity. Once those and other deductions are taken, there may be little corporate profit left to tax. But shareholders do have to pay tax as individuals on any dividends they receive from the corporation.

Self-employed business owners get another important tax break when they incorporate: They no longer have to pay the self-employment tax. As a sole proprietor, you pay your full Social Security and Medicare tax liability, which in 2007 is 15.3% on the first $97,500 of your net earnings from self-employment. For earnings above that, you pay Medicare tax of 2.9%. As an employee of your corporation, the firm withholds half of your employment tax from your paycheck and pays the other half for you.

Updated for tax year 2007