Should you incorporate your small business?

Q: I’ve been told that I should incorporate my business. But I’m not sure why or what type of corporation? It’s all very confusing.

— Tia

A: For a small business, there are three main corporations to choose from: C corporations, S corporations and Limited Liability Companies (LLCs). There are pros and cons to each kind, but the good news is that they all offer important legal protection:

• Incorporating creates a “corporate shield” which protects you from legal responsibility and personal liability for business debts. So if something goes wrong in your business, your corporation is at risk, not you personally (or your personal assets.)
• Unlike sole proprietorships and partnerships, corporations can last in perpetuity.
• Owners of a corporation (i.e., the shareholders) can share in its profit but do not have to be involved in the day-to-day operations of the business.
• A business may be taken more seriously if it has an “Inc.” or “LLC” after its name.

The downsides to incorporating are relatively few:

• Creating a corporation may require that you hire a lawyer so it can be expensive.
• Corporations are subject to more government regulations than sole proprietorships and partnerships.
• Taxes are more complicated for corporations and usually require assistance of a lawyer or an accountant.

Usually, the question for most small businesses is not whether to incorporate, but what type of corporation to choose.

S versus C Corporations

There are two basic differences between S and C corporations (S and C are subsections of the tax code.)

The first, and a major reason many small businesses are not formed as C corporations, is that C corporations are taxed twice: Once on profits, and again when profits are passed onto the shareholders.

S corporations, on the other hand, pay no corporate tax. Instead, all profits are passed on to shareholders’ personal tax returns and profits and losses are reported there. Accordingly, S corporation profits are only taxed once.

The second difference has to with size. There is a limit to how many people can own shares in an S corporation (75), but there no such limits for C corporations. Therefore, the ability to sell shares is a major advantage of a C corporation. Stocks bought and sold on the New York Stock Exchange are shares of C corporations.

The one advantage a C corporation offers small businesses is that it can deduct 100 percent of health insurance it pays to its employees (including you). Despite that, many small businesses do not incorporate as C corporations.

S Corps versus LLCs

There are two types of Limited Liability Companies. The first, called “member managed,” is when owners actively run the business. The second, called “manager managed,” is when managers run the business. LLCs are relatively new entities that have become popular.

First, like S and C corporations, LLCs protect their owners from personal liability for business debts. Second, LLCs are flexible. For example, S and C corporations have stringent record-keeping formalities. But LLCs require much less rigorous paperwork. Also, S corporations must distribute their profits with a percentage of stock ownership in mind, but LLCs can be more creative.

On the other hand, S corps have an advantage when it comes to taxes. Owners of an LLC are “self employed” and must pay the 15.3 percent self-employment tax (for Medicare and Social Security). S corporations only have to pay that tax on the amount of salary paid to the employee-owner; and any remaining income paid as a distribution is not subject to the self-employment tax.

Which is best?

I hate to sound like the lawyer that I am, but it depends. If the self-employment tax is killing you, then an S corporation may be the way to go. If business formalities and record-keeping are not your strong suit, an LLC may be your best bet.

The smart answer is to speak with your lawyer and accountant about these options. It’s important to get expert help because the downside of making the wrong decision is significant.

The other thing to do is to surf over here to get a better idea of what else is involved in starting a new business.

Steve Strauss is one of the country's leading small business experts, a columnist for USATODAY.com, and the author of the "Small Business Bible." If you would like to have Steve speak to your group, or to sign up for his free e-newsletter Small Business Success Secrets!, visit his Web site. Have a question for Steve? Send him an e-mail.