Incorporating is a big decision, but it’s often one that small business owners, entrepreneurs, and self-employed contract or freelance workers overlook or neglect.
In order to take proper advantage of all of the benefits associated with incorporating, you need to understand your company’s options: there’s more than one way to incorporate.
Different types of incorporation
The two most common methods of organizing a company are LLC (Limited Liability Company) and S-Corp (which is named after subsection “S” of the first chapter in the Internal Revenue code book). Less common options include C-Corp, which applies to publicly held companies too.
Three major options may not seem like much, but note that each state applies its own laws for each organization structure, and you’ll see why this choice is never easy.
Both LLCs and S-Corps offer the business owner benefits beyond a sole proprietorship. The carrot at the end of either stick is the protection of your personal assets and the assets of anyone employed under you. Limited Liability is even a part of the LLC’s name, and using this organizational format or an S-Corp does in fact limit litigation liability as well as debt repayment responsibility to your company’s resources while protecting any personal accounts.
Another fringe benefit of incorporating via LLC or S-Corp comes during tax season. While the owner of a sole proprietorship is still required to pay all kinds of personal taxes, the owner of an S Corp or LLC gets breaks and reductions and deductions, on both personal and corporate taxes.
So far, both the S-Corp and the LLC seem to offer the same legal and financial benefits, so what distinguishes one from the other? For many companies, the S-Corp is the superior choice, but because the layman is more familiar with the LLC, owners often choose to incorporate as such, and opportunities to save money are missed.
When and why to choose the S-Corp
1. To pay lower taxes
S-Corp owners are also salaried employees of their companies. They pay themselves a designated salary and receive dividend payments based on their company’s profits.
This is better than the “pass-through” model of an LLC in a couple of ways. In an LLC, the profits “pass” directly through to the individual owners, and this is reflected on their tax returns (a good thing, since it protects owners from double taxation).
But the deal isn’t nearly as sweet as that offered by the S-Corp. Why? The S-Corp was actually designed as a tax reduction business model — hence its name reflecting the tax code. In fact, LLC owners often seek opportunities where their LLC can be taxed more like an S-Corp.
2. Reap the fruit of your labors
As an LLC owner, you must never mistake business for pleasure. Although the company’s funds “pass through” when tax season comes, they cannot pass through at any other time.
If the business begins to do extremely well, the only way an LLC owner will feel that burst is through a salary increase, and those must adhere to industry standards. While the rules for starting an S-Corp may be more strict, and the start-up cost higher, if your business model predicts high profits, an S-Corp is wiser.
3. To avoid self-employment tax
Even though LLCs are designed to eliminate double taxation, owners are responsible for paying self-employment tax. The owners of S-Corps pay little or no tax for self employment, and even a C-Corp requires double taxation of the owner and company, because the company is treated as a separate entity.
Even after thorough research, you should always consult a lawyer who’s familiar with your state’s particular tax codes before you choose between a LLC and a S Corp. If you’re looking for additional information or online help, try consulting a guide that offers a detailed breakdown of each corporate model for comparison.