Consultants, freelancers, contractors, and other self-employed professionals make up a substantial portion of our nation’s economy. Each year, these individuals face the question of whether to incorporate their business, which essentially means they need to decide if they would be better off legally separating their work life from their personal life.
So when should a self-employed person to take this step? Sole proprietors should periodically assess the status and health of their business in light of the major benefits of incorporation—when the advantages seem worth the undertaking, it’s time to make things official.
Perhaps the most critical benefit of incorporation is that it protects the owner’s personal liability. Sole proprietors operate with all their personal assets at risk—from their bank accounts to their homes. Once the business is officially its own separate legal entity, the owner can no longer be held personally responsible for debt the company incurs or for legal matters that come about from its activities or products.
Tax savings is another advantage that weighs heavily in many self-employed individuals’ decisions to incorporate. The various corporate structures have different tax benefits. For example, a freelance artist pays federal and state income taxes, plus employment taxes to cover Medicare and social security; meanwhile, a single shareholder of an S corporation only pays self-employment taxes on the amount of salary they are paid—meaning a substantial part of their income can be reinvested in the company or distributed as a dividend to the shareholder.
Sole proprietors need to review their options (a tax professional can provide invaluable insights here) to determine which type makes the most sense for them based on factors such as the number of shareholders, employees, and net income.
Incorporation also positions businesses for future growth down the road. For companies that anticipate hiring more employees, opening a second location, or expanding their product lines, incorporation is a key step toward securing additional funding and gaining credibility as an official, reputable entity. Once an owner’s business and personal assets are separate, he or she has more freedom to apply for business loans, take on equity investors, or, eventually, sell the company.
If you think it might be time to incorporate your sole proprietorship, contact your tax or accounting professional to discuss how these benefits apply to your unique situation.