The first thing you need to understand here is why you should incorporate a business. It’s entirely possible – and legal – to just take work as it comes in and cash the checks without appending an “Inc.”, “Corp.” or “LLC” to the end of your business cards. And for a while, that might just work.
But if someone decides to sue your business for making a mistake or to collect on a bill, they’re suing you. You are the business. All of your assets are potentially on the line. Your house and car and savings aren’t legally separated from your business liabilities. It’s also harder to raise money from a bank, protect your trademarks and business name, or hire good workers as a sole proprietorship. Frankly, incorporated businesses are just more credible.
An unincorporated business is called a sole proprietorship when it’s owned and managed by one person. It’s a simple structure because it’s no structure, really. You report your business profits and losses on your own tax form as income. If you want to quit, you just quit. You are the business.
Here are some tax forms you should get to know if you’re going this route:
Schedule C: Profit or Loss from Business (or Schedule C-EZ)
Schedule SE: Self-Employment Tax
Form 1040-ES: Estimated Tax for Individuals
Form 4562: Depreciation and Amortization
Form 8829: Expenses for Business Use of your Home
Incorporating your business is not the same as obtaining a business license. Incorporation is a form of legal self defense. Incorporation can also allow you to claim some business expenses with some tax advantages . . . and some disadvantages. Depending on how you incorporate, some of your profits can be taxed twice – once at the business level, and then again as your income tax.
Most of the time, small business owners will be deciding between incorporation as a partnership, a limited liability company, or an S corporation. Depending on your field, you might even want to incorporate as a not-for-profit entity. Incorporation costs and rules vary from state to state. Some states such as Nevada and Delaware specialize in making the incorporation process as painless and as legally advantageous as possible.
State Web sites for incorporating businesses
Alabama Alaska Arizona Arkansas
California Colorado Connecticut
Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana
Nebraska Nevada New Hampshire New Jersey New Mexico New York
This decision can have long-term implications. We’ve partnered with a few services to help people incorporate their businesses. You should consider talking with one to see how best to limit your legal risk and your tax liabilities.
Partnerships
Think of it as a shared proprietorship – most of the advantages and disadvantages of single ownership apply, only there are two or more people sharing ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. Profits pass through without being taxed twice.
To do this right, you’ll need a legal agreement with your partners about how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, and what steps will be taken to dissolve the partnership when needed.
If you and your husband or wife run a business together and haven’t incorporated, you’re in a partnership. You’ll need to file taxes using form 1065, U.S. Return of Partnership Income, and not the Schedule C or Schedule C-EZ form for business income. You can thank us later.
In a General Partnership (GP), partners divide responsibility for management and liability as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
In a Limited Partnership (LP) and Partnership with limited liability (LLP), most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short-term projects or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.
A Joint Venture is like a general partnership with a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such as well as distribute accumulated partnership assets upon dissolution of the entity.
Subchapter S Corporations
A corporation is like a person – it can be taxed, it can be sued, and it can enter into contractual agreements. Shareholders own corporations. Shareholders elect a board of directors to oversee the policies. The corporation exists until the shareholders will it out of existence – it does not dissolve when ownership changes.
Normally, incorporating can increase your taxes because dividends paid to shareholders are not deductible from business income; thus, it can be taxed twice. But S Corporations avoid this problem. S Corporations enable shareholders to treat the earnings and profits as distributions and have them pass through directly to their personal tax returns. But if the shareholder – you – work for the company, and if there is a profit, you have to pay yourself wages. And they have to be real wages, whatever you would have to pay yourself to do your job, not $1 a year. If you don’t, the IRS can reclassify all of the earnings and profit as wages, and you will be liable.
Limited Liability Company (LLC)
Incorporation as an LLC will get you the most important advantages of an S Corporation – the tax advantage and the legal protection – without imposing the reporting rules of an S Corporation.
LLCs may not have more than two of the four characteristics that define corporations: Limited liability to the extent of assets, perpetual existence, centralization of management, and free transferability of ownership interests. Most LLCs periodically renew their status every year or so and separate their management so that more than one person has decision-making power.
LLC’s are cheap and popular, but some tax credits can only be claimed by full-blown corporations.
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That pretty much sums it up. It is a very easy thing to do these days since you can do it online in a matter of minutes, pay the $300 or so and they mail you the papers.
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