Now that your 2012 taxes are history, it’s time to breathe a sigh of relief. Another tax day has come and gone. And if you’re self-employed and operating as a sole proprietorship or a partnership, you dutifully filled out your Schedule SE and paid your self-employment taxes. I bet it made you wonder where all your hard-earned money went.
Maybe you’ve heard that you can lower your taxes by incorporating a business or forming an LLC and electing to be taxed as an S Corporation. The end of one tax season is the perfect time to evaluate what’s next for your business and make any necessary changes so you’ll be ready when next year’s tax day rolls around. And if you’re considering starting a business this year, you now have the opportunity to create a legal business structure right from the start.
Here are two questions to ask yourself – and answer – to see if you should incorporate now.
Should You Incorporate Now? Two Questions You Need to Answer
1. Are you looking to reduce your self-employment taxes?
The S Corporation and LLC are popular business structures for small businesses, partnerships, freelancers, and entrepreneurs.
Both entities let you “pass through” your taxes, meaning the company itself doesn’t pay taxes, but profits and losses are passed on to your personal tax return. Maybe that sounds like how it works with a sole proprietorship and a partnership, but there’s one essential difference.
Sole proprietors report their business income on a Schedule C and pay self-employment taxes; partners in a partnership report their income on Form K-1 and pay self-employment taxes on their share of the income. As an S Corporation (or LLC taxed as an S Corporation), you’re able to split your profits into two payment types: salary and S Corp distributions.
You pay social security/Medicare tax (the employer’s version of self-employment tax) only on the salary portion. Meaning, if your business made $75,000 in profit, you can pay yourself $50,000 in salary and $25,000 in distributions. You’ll only need to pay the social security tax on the $50,000 in salary.
However, you can’t be sneaky and pay yourself $5,000 in salary and $70,000 in distributions. The IRS requires you pay yourself a “fair and reasonable” salary and they do watch this closely. This means you’ll need to pay yourself a fair market rate for whatever services you provide to the company. Yet even with this, in many cases, small business owners can significantly reduce their self-employment taxes by setting up as a corporation or LLC. Bear in mind that every business has a unique financial situation and it’s always wise to consult with a tax advisor or CPA on your own situation.
2. Do you want to protect your personal assets?
In addition to giving you the opportunity to save money on taxes, incorporating or forming an LLC for your business has the important job of protecting your personal assets.
When you’re a sole proprietorship or general partnership, your own personal savings and property are at risk to settle any debts of the business. Once your business becomes a corporation or LLC, it exists as a separate legal entity. That helps to form a shield or barrier between your own personal assets and the assets of your business. You get important peace of mind that your retirement savings won’t be wiped out if something happens with your business.
Act Now for 2013
Running your own business is one of the most exciting and empowering things you can do. Just make sure to invest some time in getting your legal structure squared away and your business will be safe and set for many tax days in the future.
Editor’s Note: This was originally written by Nellie Akalp on The Mogul Mom.