Under the best of circumstances, incorporating a business can be a complicated and confusing process.
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Wouldn't it just be easier if you could keep some of the benefits of a sole proprietorship while getting some of the advantages of a traditional corporation? Well, maybe you can.
It's called an S-corporation and for many small businesses it provides the perfect hybrid between a sole proprietorship and a corporation. However, S-corps are also subject to certain limitations that may restrict your company's activities. The bottom line is that if it's time to move beyond a sole proprietorship or partnership structure, you need to know the facts about your options.
When most people think about corporations, they actually have C-corporations in mind. A C-corporation is a business entity that is capable of maintaining a life of its own, at least in the sense that it is allowed to retain its own profits. The corporation is taxed on profits at corporate rates and dividends are taxed to the company's shareholders.
It's also important to not that C-corporations are subject to more formal requirements than sole proprietorships, partnerships, and even S-corporations. These requirements include (but may not be limited to) annual reports, boards of directors, and federal reporting.
C-corporations are especially attractive to small businesses that are currently profitable or plan to be profitable in the near future because the company's owner can avoid claiming the business' profits on his personal tax return and instead allow profits to be taxed to the corporation.
Unlike C-corporations, S-corporations are pass-through business entities. This means that all of the company's income is passed through to the company's shareholders who then claim it as personal income rather than corporate income. This eliminates the "double taxation" of profits that are taxed at the corporate level and then again when dividends are passed on to shareholders.
S-corporations are subject to more requirements than sole proprietorships and partnerships, although these requirements are not quite as stringent as they are for C-corps. However, to classify as an S-corp, the company cannot have more than 35 shareholders and is limited to domestic capitalization.
S-corps are an appealing option for small business owners who want the advantages of a corporation (e.g. not being personally liable for the company's debts and liabilities) without the additional burden of requirements involved with a traditional corporate structure.
Regardless of whether you decide to become a C-corporation or an S-corporation, you should know that as the owner, you cannot simply take a draw on profits. Instead, you will need to establish a wage for yourself and withhold standard payroll taxes and deductions.