Understanding IncorporationAccording to the Internal Revenue Service (IRS), incorporation involves establishing a separate corporate entity created under a state’s laws through the submission of articles of incorporation to that state. In this business arrangement, the shareholders own the company and one or more directors run it. Worth noting is that, while many businesses do incorporate, incorporation is not in all cases a legal requirement for doing business. In many instances, companies can and do operate without becoming incorporated; either as one of several forms of business partnership (in the case of more than one business owner), or as a sole proprietorship (an option that is typically most applicable to a person producing goods or offering services independently, under their own name). Partnerships and sole proprietorships are subject to different tax regulations from those that apply to corporations.
What Is the State of Incorporation?State of incorporation, also called state of formation, simply means the location in which the business decides to register. If a corporation registers in Delaware, then Delaware is the business’s state of incorporation. Each state splits incorporated firms into two categories, which are inactive and active, and has unique corporate laws that govern corporations. Additionally, the IRS assigns corporations to specific classifications depending on how the business decides to register, such as C or S corporation categorizations. Many corporations opt to register in Delaware since many of its laws are corporate-friendly and the state can offer firms favorable tax codes. Those looking to register a new business can find plenty of useful information by visiting the United States Small Business Administration’s (SBA) website.
How Does Owning a Corporation Affect My Personal Taxes?When a business owner opts to incorporate their company, they receive an extra tax layer. For these firms, the corporation pays taxes on any profits generated by the business. If the business pays a salary to the owner, or if the owner receives any other distribution from the company, the owner pays personal income tax on these earnings. Some corporations can receive an S classification from the IRS if they meet certain requirements. If this happens, the IRS treats the corporation’s income as personal earnings, meaning they tax it as personal income rather than at the corporate tax level.
Is There a Tax Disadvantage to Incorporation?Incorporated firms typically file two tax returns each year: namely, income tax and corporation tax. This means incorporated firms must complete additional paperwork and legal formalities compared to other business structures that only file a single return. Unlike sole proprietorships, incorporated companies cannot deduct business losses from the owner’s personal tax liability. Discover more about the state of incorporation and explore how a California corporate lawyer can assist new and established business owners by arranging a consultation with L.A. Tech & Media.
What Are the Major Disadvantages of Incorporating a Business?In addition to the tax implications, which depending on the situation may pose inconveniences for the business owner, there are a few other possible disadvantages to incorporation. Key drawbacks to incorporating a business include the following:
- Additional start-up costs: In comparison with other business structure types, incorporating a company often takes longer, requiring the business owner to file documents with the state office that is responsible for chartering corporations, and may entail additional start-up costs. This is largely because corporations are more complex legal entities than sole proprietorships or partnerships. Setting up an incorporated firm can cost hundreds of dollars initially, and also requires the paying of annual fees.
- More paperwork: In addition to completing another tax return, incorporated firms require the need for other paperwork that is unnecessary for more simple business structures, like sole proprietorships. These include taking meeting notes to document internal deliberations, conducting thorough bookkeeping, maintaining audit books and bank records, and creating share registers, transfer registers, and business reports. Creating an incorporated business also requires the business owner to set up separate business bank and credit accounts, which entails collating the necessary business identification documents, and keeping their personal and business funds distinct throughout the firm’s lifetime.
- Potential ownership issues: Incorporated firms might choose to sell stocks to raise funds, leading to new shareholders. These individuals could potentially influence the business’s operations. This is because, in incorporated companies, the shareholders vote to elect the directors who manage the business.
How Does the Business Benefit From Being Incorporated?Establishing an incorporated firm offers several advantages, including:
- Securing assets: One of the major benefits of incorporation from a business owner’s perspective is that the establishment of the business venture as a separate legal entity limits the owner’s personal liability. Owners of incorporated businesses are not usually considered to be personally liable for the corporation’s debts and liabilities.
- Benefiting from tax breaks: Incorporated businesses enable owners to enjoy multiple tax benefits, such as the ability to write off self-employment tax savings, and health insurance and life insurance premiums. In addition, corporations can gain extra tax savings if the firm operates in a state where the level of corporate tax is below the personal tax rate and the corporation is not distributing any income to its shareholders.
- Enhancing credibility: Incorporating a business tends to boost its credibility, which can help the company secure new commercial relationships and attract additional customers.
- Raising funds and transferring ownership: Incorporated firms can easily raise funds by selling stock and it is often more straightforward for these firms to take out loans. Generally, it is also a simple process to transfer ownership of an incorporated company, although some restrictions exist for S corporations.
- Preparing for retirement: Often, it is easier for incorporated businesses to establish retirement funds, such as 401(k)s, allowing these firms to attract more potential employees.
- Gaining anonymity: Some owners opt to incorporate their small businesses to prevent their ownership of the firm from becoming public knowledge.