How to know when to incorporate your business

Take notes for when the time is right

You started your business with just you, or maybe just you and a partner. That was all you needed. When you set up your business, you just went with a sole proprietorship or a partnership. It’s likely you weren’t giving much thought about when to incorporate.

However, things have changed.

You started growing and thinking that maybe you do need to incorporate. However, how do you know when to incorporate your business? Let’s look at five signs you need to incorporate.

1. You need more protection for your personal assets

When To Incorporate Taxes

When you are a sole proprietorship, your entire life is susceptible to being taken away if your business is sued. If you make a mistake with a client and they file a lawsuit, your personal assets are fair game to be seized to pay for any legal settlements that you cannot pay for out of the cash in your corporate account.

Knowing when to incorporate gives you an added layer of protection between your business’s assets and your personal assets.

If an irate customer decides to bring a lawsuit against your company, they can only go after the company’s resources. Your personal assets are safe and practically untouchable.

2. Easier to pass on the business to your heirs

If you are a sole proprietorship, the business is in your name only. However, many times people set up a business with the hopes of passing it onto their children. They will sometimes bring in the kids to work in the business while in their teens to teach them about the enterprise.

However, if you remain a sole proprietorship, the business will cease to operate as it was only listed in your name.

Deciding when to incorporate your business lets you determine how many shares of stock your business will have available to distribute — to your kids, for example — either through a sale or through your estate when you die. This is why corporations are said to “have perpetual life,” since the ownership of the company can be passed to new shareholders with the sale of stock in the company.

3. You need more credibility

Your business might have an excellent reputation in the business community, and your sterling character may be the model for business people everywhere. However, when it comes to financing, a sole proprietorship isn’t held in the highest regard by banks and investors.

When you decide when to incorporate, you can demonstrate the commitment to your enterprise, showing that you intend for the company to be more than a hobby you will abandon in the next year or so. Incorporating gives lenders and investors the confidence to provide funding to grow your business.

4. You want to bring in more talent

By offering stock as compensation, you can offer high performers a chance to build something and have a say in how the company operates. In addition, providing stock to advisers and giving them a seat on the board of directors gives them an incentive to provide guidance in the best interest of your company. This might sway your decision about when to incorporate.

5. Tax benefits

If you are considering when to incorporate, consider the tax benefits. The first one is being able to deduct the salary you pay yourself. As a business owner filing a Schedule C for your business as part of your 1040 return, you are not allowed to take a deduction for a salary you pay yourself.

The IRS assumes any dollar you make is going straight into your pocket, and is therefore subject to personal tax rates.

With a corporation, you are allowed to deduct a salary you pay yourself, and any income earned is taxed at the traditionally lower corporate tax rates. Furthermore, you will only be taxed on amounts distributed to you, whether it be the taxes on your salary, or dividends and capital distributions. Unlike a sole proprietorship, you can build up a corporate reserve without having to pay personal taxes on it until it is distributed to you via dividends and capital distributions.

Knowing when to incorporate

Are you ready to take on the additional regulatory requirements of being a corporation? There are quite a few reasons to incorporate. If you have a good set of advisers, including a good accountant and legal professional to guide you, you might want to consider incorporating your business.

The above content should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.


Also published on Medium.

Image by: The Climate Reality Project on Unsplash

Chris Peden
Chris Peden, CPA, CMA, CFM has spent more than 15 years in the corporate world helping companies meet their regulatory compliance requirements. He also assists small business owners with organizing and making sense of their finance information.