Being a sole proprietor is great. It's so easy! You can literally just start doing it with a minimum of paperwork and very little excess effort... at least until tax time rolls around. Once your business is established, though, it may no longer be the best option for your business. That's when it's time to incorporate and start on your incredible journey to owning a very tall building. Or maybe just an office that's not also at your house.
Incorporating sounds complicated, like something only a wealthy banker would have any business doing. It isn't all that difficult though. It's really just a matter of choosing the best corporation for yourself and for your business once you've determined it's the right time to take this step.
This article looks at for-profit corporations. We have a separate guide to forming a non-profit organization if you're looking to do so.
Limited Liability Corporation (LLC)
If you're wondering why you'd want to incorporate, the two Ls in LLC should give you at least one very good reason: your liability is limited.
If you were to fail or fall behind on payments as a sole proprietor, creditors could come after your personal property. But if your business is an LLC, your own property is protected. The LLC could, for example, declare bankruptcy without you personally needing to go bankrupt.
Running an LLC also keeps your taxes simple (relatively speaking) since all money made by an LLC passes-through to the owner(s) of that LLC. That means you'd continue to pay taxes as a sole proprietor even through your business is structured as a corporation. This would be true even if you went into business with someone else, since members of an LLC are considered self-employed.
How to get started?
You'll need to file Articles of Organization with your state. Though the process is similar regardless of where you are, each state is different enough that it's worth googling “Articles of Organization
Are there any negatives to forming an LLC?
Other than the extra paperwork and the possibility that you may consider it a negative to continue paying taxes as if you're self-employed, the major negative is that should you start an LLC with another person (or people) then if any of those people later decide to leave, the entire LLC has to be broken up. It can't continue to exist without all of the owners remaining on board.
An S-Corporation is not terribly different from LLC aside from a couple of notable things:
- Ownership can be transferred. If a shareholder wants to leave an S-Corporation, then they can do so by transferring or selling their share in the company to someone else, which means an S-Corp can continue to exist even if all its original owners leave.
- Cheaper Taxes. An S-Corp owner can be an employee and paid as such, with taxes withheld on that salary. Excess earnings above and beyond the salary can be distributed as unearned income that would be subject to lower tax rates. Though you'd want to consult a tax professional to ensure the IRS was happy with how you were approaching a salary vs distributions.
How to get started?
You'll have to file Articles of Incorporation with your state. Much like with an LLC, these steps will vary from state to state, so in this case it'll be worth googling “Articles of Incorporation
After this is done, you'll then need to file a Form 2553 with the IRS. The IRS hosts this form, as well as instructions for filling it out, on the appropriately named S-Corporations section of their site.
Are there any negatives to forming an S-Corporation?
Paperwork! An S-Corporation is significantly more formal than an LLC, requiring that you have fully written out by-laws, hold board meetings, maintain detailed minutes of those meetings and generally keep eternal note of everything the business has been doing. Probably not the right move until your business grows beyond yourself and your business partners.
A C-Corporation is also what's just commonly called a Corporation. What makes it different from an S-Corp?
Corporate Income. In an LLC and S-Corp, all income earned (or lost) by the corporation is passed on to the owners (or paid to employees) who then pay the appropriate taxes as individuals. This is not true of a corporation, which can hold money separate from its ownership. All gains and losses are taxed at the corporate level, with owners then paying income taxes only on the salary and distributions they receive.
Capital. A C-Corporation can sell shares of itself in order to raise money. This is the business model of roughly 95% of all tech companies.
How to get started?
You'll have to file Articles of Incorporation with your state. This is the same first step that was reference for creating an S-Corp so you'll want to Google “Articles of Incorporation
Are there any negatives to forming a C-Corporation?
You may have noticed the potential negative under the Corporate Income section above. Profits are taxed at the corporate level and at the individual salary/distribution level. If you run a small business and don't expect to make more money than you pay out to yourself and your employees, then you'll essentially end up double-taxed on your income, since you'll pay a corporate rate and then pay income tax on your salary. With an LLC and S-Corp, you're only paying income tax.
For this reason, forming a C-Corporation is the best choice if you're looking to raise capital or plan/expect to grow to be a company with more than a few employees.
Regardless of the path you choose now, you can always form a different type of corporation later. It may be that you start as an LLC, move to an S-Corporation, and then end as a C-Corporation building a one thousand foot HQ tower in NYC. As you follow this path of success, though, there is one thing that's certain: you should consult a tax attorney in your area to make sure you're doing things the right way.