My business is currently structured as a sole proprietorship, should I incorporate?

​Below you'll find information on the most common entity classifications to understand and consider, as well as info from the tax perspective, liability side of things, and company ownership details.

Sole Proprietorship
A sole prop is the simplest form of company ownership and is essentially the automatic classification if the company isn't registered as any other entity. A sole prop doesn't create a separate business entity, leaving the owner potentially exposed to liability. Sole props are well advised to acquire E&O Insurance (errors & omissions) or some kind of other liability protection policy. This type of classification is best for business owners who operate as a "one owner shop" in the beginning stages of business, who don't want to go to full formal lengths before knowing the viability of their businesses. Sole props are taxed directly on the individual return through a Schedule C, which nets out income and expenses of the business to arrive at a net profit or loss.

Partnership
Partnerships are often chosen once a business involves two or more people. Partnerships can help limit the liability of individual partners and are often chosen by professional groups like attorneys or medical professionals. Similar to sole props, this classification is often suited for beginning stage businesses testing out the viability and profitability before advancing to more detailed arrangements. Partnerships require the preparation of a separate business tax return, that then "kicks off" K-1 tax forms to each partner for their respective share of profit/loss reporting. The K-1 is then ultimately reported by each partner on their own personal tax returns.

LLC (Limited Liability Company)
LLC's are a very common type of entity classification since they're relatively simple to form, and they protect owners from personal liability in most cases. Personal assets are generally shielded from risk in the event of the LLC being sued or facing bankruptcy. LLC's have flexibility in tax classification as they can elect to be taxed as a sole proprietor, which is the most common for LLC's and doesn't require a separate company tax filing, per above. Or LLC's can elect to be taxed as a partnership or corporation, which requires a separate business tax return to be prepared. LLC's are often chosen by businesses that inherently carry more risk than sole props where the owner(s) feel like insurance coverage is not adequate and they want the added corporate protection. Each state has different filing requirements and taxation rules on LLC's. Some states have no annual income tax filing requirement separate from the Schedule C reporting, while others (like CA) have an added tax filing (568 form) necessary to reconcile the annual LLC fee (minimum of $800 for CA). So the LLC provides added protection, but takes on additional expenses versus a sole prop due to the added tax preparation costs, as well as LLC fees imposed in some states.

C-Corporation
C-Corps provide legal entity protection for its owners and require the preparation of a separate tax return. C-Corps offer the strongest personal liability protection, but entail much higher costs than other structures, as well as more involved record-keeping and compliance. C-Corps are said to be double-taxed, since the entity files its own tax returns and pays its own taxes on profits, and then shareholders pay taxes on dividends received and reported on their individual tax returns. C-Corps are generally chosen by larger companies with multiple owners/shareholders, in need of high risk protection, and looking to raise capital by way of stock offerings.

S-Corporation
Smaller businesses will more commonly elect to be an S-Corp in order to avoid the double-taxation of C-Corps. Like the other corporate structures, S-Corps provide liability protection for personal assets. S-Corps file their own tax returns and then provide K-1's to shareholders & owners like that of Partnerships. With S-Corps, there are tax savings considerations due to the ability to structure pay where corporate officers take profit distributions as some income versus all in earnings. The savings comes into play as distributions are only subject to federal and state taxes, whereas earnings are also exposed to payroll taxes (social security, Medicare, etc.). However, S-Corp pay structure does need to pass the IRS tests in regards to reasonable compensation being paid to corporate officers, in order to avoid taking too much pay as distributions for the purposes of avoiding the payroll taxes. There are many considerations here that should be discussed with a qualified CPA/Tax Preparer before electing this entity type and setting up its corresponding pay structure.

For added detail on business structures, visit the Small Business Administration site by clicking here.

In addition, we recommend speaking with a qualified tax attorney for more information on incorporating.