Have you been thinking about incorporating your small business or self-employment activity? The advantages are many!
For starters, you'll be protecting yourself and your family from the
possibility of a business ending lawsuit. Forming a corporation is Step
One on the path known as "Asset Protection" -- you are moving from the
world of unlimited liability to the world of limited liability.
(NOTE: For further insight into the legal advantages of incorporating,
check out the article: "It Can Happen To You: Why Any Sole
Proprietorship Is A Risky Business" at
http://www.YouSaveOnTaxes.com/happen-to-you.html)
From a tax standpoint, there are both advantages and disadvantages to
incorporating. Yes, forming a corporation can either reduce your taxes
or increase your taxes, depending on what type of corporation you
create.
There are two main types of corporations: "C" Corporations and "S"
Corporations -- and which type you choose can make all the difference
in the world of taxes.
NOTE: The question of "C" Corp vs. "S" Corp has no effect on the asset
protection provided by your corporation. This is a tax issue, not a
legal issue.
A "C" Corporation can lead you into a Tax Trap known as "double
taxation". Yes, income from a "C" Corporation can actually be taxed
twice -- once when it's earned on the corporate level and again when
it's paid to you, the shareholder, in dividends.
There are several ways to avoid double taxation. Often the easiest way
is to tell the IRS that you choose to be an "S" Corp instead of a "C"
Corp. The profits of an "S" Corp are not taxable to the corporation;
instead, those profits are reported directly on the shareholder's
personal income tax return and are therefore only taxed once.
And once is enough, don't you think!
Of course, any article on Choice of Entity must contain the old
disclaimer, "Consult your tax professional" -- I am not prescribing a
one-size-fits-all approach to this issue. But for many small biz owners
and self-employed folks, the "S" Corporation is a good fit because it
provides protection from personal liability and avoids the nasty tax
trap of double taxation -- two great benefits worth checking into.
Should you incoporate your sole proprietorship and then decide that the
"S" Corporation is the right fit, you must inform the IRS that your
corporation is choosing "S" Corporation status by filing Form 2553,
which is, in effect, an application to become an "S" Corporation.
IMPORTANT:
If you incorporate and do not file Form 2553, you are automatically
considered to be a "C" Corporation by the IRS. In other words, to be a
"C" Corporation, you just incorporate; there is nothing you have to do
to inform the IRS you want to be a "C" Corporation.
There are critical rules regarding how and when to file Form 2553, so
be sure to read the instructions carefully, or check with your tax pro.
Failure to file Form 2553 on time or filing Form 2553 incorrectly
results in a rejection of your corporation's "S" Corp application, and
the corporation is then by default treated as a "C" Corp, subject to
double taxation, the very trap you were trying to avoid.
To download a copy of Form 2553, go to: http://www.irs.gov/pub/irs-pdf/f2553.pdf
The instructions for filing Form 2553 are found here: http://www.irs.gov/pub/irs-pdf/i2553.pdf
