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Now May Be the Best Time to Incorporate

If you incorporate or form an LLC this year, you can make a clean break for taxes. That's only one of many good reasons to take the leap.
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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.

Last updated: Dec 29, 2011

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.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.



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