By incorporating their firms, business owners create a separate legal structure that helps shield their personal assets from judgments against the company. However, companies that incorporate are taxed differently. 

A C-corporation pays its share of employment taxes and withholds certain required income and employment taxes from employees' salaries.  (If you're a sole proprietor, you probably pay periodic self-employment taxes on your entire share of your company's profits.)

A C-Corp has perpetual existence, meaning that the firm will continue even if the owner/founder dies or leaves, and adds credibility to a firm, thereby making it easier to attract investment from angel investors, venture capitalists and others through the sale of stock. C-Corps can reward employees by issuing stock options to them; people tend to work harder for a firm if they feel part of the ownership.

The C Corporation structure does have its drawbacks. For instance, a firm's profits are taxed when earned and taxed again when distributed as shareholders' dividends in what is known as "double taxation."  (Shareholders cannot deduct corporate losses, as is the case with a limited partnership or an LLC.)  A C-Corp must file quarterly taxes with the IRS, rather than annually, which is the case for an S Corporation.

S Corporations

Companies that meet certain requirements can elect to have S-Corp status. This federal tax status enables them to "pass through" their taxable income or losses to owners/investors in the business, according to their ownership stake.  (By default, companies that do not specify a tax status with the IRS are considered to be C Corporations, which means that they will be taxed as such unless they register as an S-corp.)

By choosing S-Corp status, a firm can eliminate the disadvantage of "double taxation" of corporate income and shareholder dividends. The S-Corp format also offers limited liability for company directors, officers, shareholders, and employees; investment opportunities through the sale of shares of stock; perpetual existence and a once-a-year tax filing requirement (vs. quarterly for a C-Corp).

The example below illustrates the tax advantage of electing for S-Corp status over sole proprietorship:

 

Not Incorporated: John, a sole proprietor (not incorporated), has a net income of $100,000. He pays $15,300 in self-employment taxes.

$15,300

Incorporated: John forms an S-corporation. He pays himself a reasonable salary of $60,000 and pays the other $40,000 as a shareholder dividend.  John pays Social Security and Medicare taxes only on his salary, for a total of $9,180.

$9,180

* By incorporating, John saves:

$6,120

* Ask your accountant if this strategy will reduce your self-employment taxes.

 

Many types of professionals -- doctors, lawyers, architects, accountants, engineers, and public relations people, for instance -- start their companies as sole practitioners.  However, as the company's success grows, partners and additional workers typically join.  At that point, the company must expand and change its business format. 

As Tax Day approaches on April 15, it is too late to change business format for 2012 earnings.  However, one can consider changing status in 2013.  My advice is to check with an attorney or a tax consultant to determine if it is the right move for your business.

E.J. Dealy is CEO of The Company Corporation, the small business unit at Corporation Service Company® (CSC®), which incorporates tens of thousands of new businesses annually and provides ongoing compliance services to 200,000 companies located throughout the U.S.