1. Protection for personal assets
If you operate your company as a sole proprietor or you’re a general partner, the law doesn’t see any separation between you and the company. If your business is sued and there’s a judgment against you, personal assets are at risk. If your company gets deeply into debt, you may have to declare personal bankruptcy to get out — and your own assets could be at risk.
When you incorporate, however, your business gets its own legal identity. And unless you co-mingle personal money or otherwise fail to treat your corporation as its own entity, your financial risk is limited.
If something goes wrong, business assets are vulnerable — but since you’re just a shareholder, your own wealth isn’t at risk, and losses are limited to the money you’ve invested in the company.
2. Tax flexibility — and savings
When you incorporate, you have the choice between operating as a C-corporation or electing to be treated as an S-corporation. With a C-corp, the business is taxed when it makes a profit, and shareholders are also taxed when the company pays out profits. This creates a risk of double taxation unless you’re strategic about how your C-corp operates.
If you’re an S-corp, on the other hand, profits and losses pass through to owners. Although S-corps have to file their own corporate tax returns, the company doesn’t pay any taxes itself. The owners who pay taxes have options for how their earnings are structured, which can significantly reduce their tax liability.
S-corp owners who operate the business have to pay themselves a reasonable salary, but the company can pay some of the money it earns as distributions. Why does this matter? Because you don’t have to pay self-employment taxes (Medicare and Social Security taxes) on money paid out as a distribution. This provides pretty significant tax savings, as these taxes add up to around 15.3% — or more if your income is high enough that you’re subject to an additional Medicare surtax.
So if your company earns $100,000, you could pay yourself a $60,000 salary and take the remaining $40,000 as a distribution, avoiding $6,120 in taxes.
You may also get more opportunities to take deductions for business expenses, business investments, and fringe benefits such as medical insurance premiums when you’re operating as a corporation rather than running a business as a sole proprietor or partner.
3. Simplified business succession planning
A final big reason to incorporate: it’s easier to pass the company on or to sell it to new owners.
Because your corporation is a separate entity from you, its continued existence isn’t tied directly to your involvement. You also own shares of your company when it’s structured as a corporation. This means you can transfer ownership of those shares either during your lifetime or after your death.
Valuing of the shares can be easier than trying to figure out the value of a business co-mingled with personal assets, and investors are typically more comfortable buying ownership shares of an organization than buying a business from a person.
Incorporating is often worth it
If you want to build a business that will outlast you — and benefit from both asset protection and increased flexibility when it comes to taxes — incorporating can be a great approach.
While there are some costs associated with incorporation, and the process can involve a few different steps depending upon your state laws, the benefits are often worth the effort.