Deciding when to incorporate your sole proprietorship requires examining your business goals and priorities. Many small businesses start out as sole proprietorships because it’s the easiest business structure to start. Later, when the business is growing, they might decide to incorporate. Figuring out the right time to do that can be challenging, but it starts with understanding the differences between corporations and sole proprietorships and the various reasons to incorporate.
Corporation vs Sole Proprietor
A sole proprietorship is the most common legal structure for a small business. It essentially means that the owner and the business are, for legal and tax purposes, one and the same. Any taxes owed by the business are legally owed by the individual owner. Managing the taxes for a sole proprietorship is simple — it’s the same as handling taxes for yourself. Sole proprietors don’t have to manage a lot of paperwork either; there’s no paperwork required to set up a sole proprietorship, and it’s not necessary to prepare separate financial reports, tax returns, or other documents for your business, as is required for corporations. Also, the owner is able to keep all profits of the business, but they’re also personally liable for any business lawsuits or bankruptcies.
On the other hand, a corporation is a separate legal entity from the business owner. If someone sues a corporation, they’re suing the business itself, not the owner, as with a sole proprietorship. An incorporated business may also be more effective at recruiting and hiring staff, attracting more customers, and securing business financing. But setting up a corporation does require filing documentation with the state in which you operate, and some states require corporations to submit annual paperwork.
Reasons to Incorporate
As a small business grows, there may be a number of reasons to consider establishing a more formal corporate structure. Figuring out when to incorporate is often a subjective process of deciding how important those reasons have become to you and your business. Some of the most common reasons include the following:
Reduce Personal Liability
When you incorporate your sole proprietorship, you’re no longer personally liable for business debts or lawsuits. Instead, the liability switches to the corporation, allowing you to protect your personal assets from potential damages.
Project a Professional Image
Because sole proprietorships are traditionally considered one-person businesses, companies that want to grow larger may feel held back by the single-member structure. Potential customers, especially corporate customers, may view an incorporated business more favorably, as it may appear to be more stable and established than a sole proprietorship.
Avoid Self-Employment Taxes
Although a sole proprietor pays both their personal and business taxes on an individual tax return, they’re also required to pay “self-employment taxes.” These taxes cover the portion of Medicare and Social Security tax that an employer typically pays for an employee. Because the owner is both employer and employee, they must pay both the employer’s portion and the employee’s portion of these taxes. But after incorporating, the business pays the employer’s portion and the owner, as an employee, pays only the employee’s portion.
If you’re considering incorporating your business, your accountant or tax advisor can help. They can help you determine the difference in the amount of taxes you’ll owe with a corporation vs sole proprietor. But it’s up to you to determine how much you value the professional image and liability protections that incorporating can offer.