Now May Be the Best Time to Incorporate
One of the most common questions I get as a corporate lawyer is “when should I incorporate?” Like so many questions in law, it has no clear-cut answer: There is no preset size or predetermined best time to form a business entity. If you are a sole proprietor or in a partnership, the question of forming an S-corporation, LLC or other entity has undoubtedly come up before. But even if it was not the right move then, a new year is a good time to give the question some renewed consideration.
The main reason to make the move now around the change of a calendar year is to cleanly break from a personal tax filing to a corporate tax return. But there are other benefits as well to incorporating or starting an LLC. Let’s go over some of them:
You can deduct losses for as long as you have them. As a sole proprietor, you can only turn a loss for so long. Three years in a row, to be exact: you can lose the ability to deduct certain losses on your taxes if you fail to show a profit during three of the last five tax years. If 2012 will be your third year in business (or more) double check your 1040 Schedule Cs – if it looks likely that you will not turn a profit, you run the risk of seeing your business classified by the IRS as a “hobby.” And guess what – hobby losses are more limited than business losses. If you reorganize into a formal business entity, you can continue to show losses without risking deductions.
A formal entity give you more tax flexibility. There are many tax reasons to move to a formal entity – depending on the entity you choose. They include:
- A corporation can offer retirement and medical plans along with greater retirement and life insurance contribution limits than a sole proprietorship or partnership.
- There are no limits or restrictions on the amount of capital or operating losses that a corporation may carry forward or backward to other tax years.
- With a corporation, only salaries (and not the entire profits of the business) are subject to payroll taxes. All income outside of a formal business entity, on the other hand, is subject to self-employment taxes. As of 2011, the combined tax rate is 13.3% on the first $106,800 of income.
A legal business entity lets you keep the business going. A sole proprietorship or partnership terminates when an owner retires or stops working, but a corporation or an LLC keeps going. A legal business entity can live on indefinitely until it sells or transfers ownership, merges with another business or shuts down. This is particularly important if you want to keep a family business going for generations to come.
A legal business can limit your liability. A legal business entity can protect your personal assets against liability for business debts. Regardless of the time of year, limited liability is always a great reason to formalize your business. Take a look at your personal and business situations; both are relevant to making the call here. The status of your company – its growth, customer base and potential liability – and your personal finances should all factor into your decision.
A formal business entity can make you look more “legitimate.” Even though this is not a legal reason, many entrepreneurs find that a formal legal business entity gives a little gravitas to a business. It tells their customers “I’m taking this seriously.” For many, taking the step from a sole proprietor to a shareholder makes entrepreneurship real.
Whatever your reasons are, look into taking your business to the next level in the New Year. If you’re the do-it-yourself type, online options are a great way to save money and time. Take advice from your accountant or lawyer if you are not sure what entity is right for you.
CHAS RAMPENTHAL | Columnist | General Counsel, LegalZoom
Chas Rampenthal is general counsel and vice president of product development at LegalZoom. He's also a former talk radio host (KTLK AM 1150 at Clear Channel) and an entrepreneur himself, as the founder of LegalEndeavor.