There are many reasons to incorporate your small business, like limited liability and new ways to raise money. However, this big investment could come with some serious tax implications. Before you take the big leap and form a corporation, make sure you prepare for how it will change your relationship with the Internal Revenue Service.
Unless you’re a financial whiz, you’re probably using single-entry accounting for your sole proprietorship or partnership. This means that you track payments and spending in a checkbook register or a similar list format. If you become a corporation, you have to move on to double-entry accounting. As the name suggests, this means you record every financial transaction twice: once in your record of credits and once in your debits. It’s a complicated system, but you and your staff can assuredly show shareholders where your business’s money goes.
Once you spend the time to convert your record-keeping system, you’ll reap the tax benefits. Intuit TurboTax reports that the U.S. government audited a full 8 percent of sole proprietorships in 2010, but only about 0.4 percent of them were corporations. Audits take up a lot of time and resources, so any way to avoid them is a good idea.
If you want to see your personal tax bill shrink, incorporation might be the way to go because business taxes are usually lower than the personal tax rates. If you earn enough from your business to reach a higher personal tax bracket as a sole proprietor, you could end up owing a lot to the IRS. According to Susan Ward of The Balance, being a corporation allows you to choose to keep money in your business you don’t need now and pay yourself later when it’s best for you.
It can be beneficial for your company to incorporate and become its own entity in the eyes of the government. However, your new corporation will need to fill out its own tax forms. Not only will you have to figure out your personal income taxes every year, you will also have to fill out additional forms for your corporation. You can certainly ask for help with your business taxes, but that could bring on additional costs you wouldn’t have with a sole proprietorship.
While it’s true that incorporating your business can save you money personally, the government taxes what you earn as a shareholder twice. Since a corporation is a separate entity from you, it pays income tax every year. When you get dividends from your corporation, you then pay personal taxes. It’s called double taxation, and Investopedia says that it is an unintended consequence of legislation. The system won’t go away anytime soon, because it prevents wealthier people from living tax-free on dividends from large collections of stock.
Incorporating your small business can help you reap tax benefits, but it’s a complicated system with very strict laws. Before you make any big decisions, consider consulting your company’s accountant or lawyer.