Incorporation tax benefits for your small business
5 min read
July 27, 2021 • Block Advisors
Did you know you don’t have to be a massive enterprise to incorporate a business? There could be tax benefits in incorporating a business. Learn about some incorporation tax specifics in this post.
First, what is incorporation?
An incorporated business, or corporation, is a legally and IRS-recognized business entity. Corporations are separate from the people owning and operating them. Its shareholders own shares of company stock and are responsible for its operation and profitability.
Various business structures have different ways of operating, governance, and tax reporting requirements.
Tax advantages of incorporating yourself
Now let’s walk through the basics of the incorporation of a company. Even the smallest of businesses could see tax benefits by incorporating their business. It’s important to note that there are legal implications to incorporation, but we’ll focus on the tax aspects as that is our area of expertise.
Below are some of the tax advantages of incorporating.
Prefer getting one-on-one help? Block Advisors’ certified small business tax pros can walk you through the tax considerations of incorporation.
1 – You could benefit tax-wise
If you are the sole owner of the business and you don’t incorporate, your default status in the eyes of the IRS is a sole proprietorship. With this business structure, you don’t need to do anything to set up the sole proprietorship because this is the default tax entity for individuals conducting a business activity. As a sole proprietor, you only need to report your business income and expenses on your individual tax return.
A sole proprietorship is often the entry point for novice entrepreneurs because it requires zero setup. Yet, it might not be the best business structure as your small business grows and evolves. Here are a few examples of the tax advantages of certain business entities:
- S corporations are pass-through entities. This means that the net profits of the company pass through to the owners’ individual tax returns and the owners then pay tax at their individual rates.
- For a C corporation, the net income of the business is taxed at the corporate level. C corporations currently have a flat tax rate of 21%, while the highest individual tax rate is 37%.
- After-tax profits withdrawn from a C corporation, referred to as “dividends,” are taxed to the shareholders. This is referred to as “double taxation.” Qualified dividends (generally, dividends paid to shareholders who have owned company stock for a specified time period) enjoy favorable capital gain rates.
- C corporations do not pay self-employment tax. Employee shareholders pay their share of FICA (Social Security and Medicare tax) and the company pays the other half.
- Although the owners’ individual rates may be higher than the C corporation 21% rate, S corporation owners can generally withdraw after-tax profits without paying additional tax. With this structure, you avoid the double taxation of profits. Also, S corporations do not pay self-employment tax. However, active shareholders must pay themselves a reasonable salary in addition to tax-free distributions. As with any employee, the shareholder-employee pays one-half of FICA taxes and the company pays the rest.
Note: An LLC (limited liability company) is a state-level entity rather than a corporation. For one-owner LLCs the default entity is a sole proprietorship; for two or more owners it is a partnership. LLC members can elect to be taxed as a corporation by filing Form 8832 with the IRS.
Now are you seeing some of the tax advantages and ramifications of incorporating yourself? If you’re contemplating various business structures, you may be interested in our other posts that compare the options:
2 – You can claim tax deductions
Like a sole proprietor or partnership, a corporation can deduct any ordinary and necessary business expense. Corporations often have additional expenses which are deductible. These might include annual franchise fees, annual report fees, and other state-level expenses. A corporation can deduct tax preparation fees as a business operating expense.
3 – It opens your business up for lending opportunities
Small business owners who don’t incorporate could face more challenges than incorporated businesses when applying for loans. One reason for this is that sole proprietorships require less financial and tax documentation. Thus, they might not have the records to substantiate their income.
In contrast, incorporated businesses often offer a clear financial picture of their business assets and liabilities to lenders, in part because of their corporate tax returns which include balance sheets as well as income and expense information.
How to incorporate your business
Think you want to take the next step and learn how to incorporate your business? For certain, there are several steps, including determining which type of entity you want to form and setting up an EIN and payroll for your business.
It’s a good idea to work with an attorney to ensure you cover all the legal aspects of incorporation such as your articles of incorporation or business bylaws.
Is incorporation of a company worth it?
There are many corporation tax benefits, but not all businesses should incorporate.
At Block Advisors, we can help you determine the tax advantages of incorporating while also guiding you to make important tax decisions about your business. As mentioned above, there are also legal implications of incorporating a business, which we recommend using a lawyer to figure out.