The primary and most important reason to incorporate is to protect your assets. Once incorporated anyone attempting to sue you in the regular course of business must limit their litigation efforts and legal requests for damages to the corporation only. Your personal assets are protected from creditors of the corporation. For instance, if a court judgment is entered against your corporation stating that it owes a creditor $100,000, you cannot be forced to use personal assets, such as your house, to pay the debt. Because only corporate assets are used to pay business debts, you stand to lose only the money that you’ve invested in the corporation.
TAXES
Corporations are taxed for the profit they earn in many different ways, depending on the exact corporate structure you choose, which will be discussed later. There are many tax advantages to having your income flow through a corporation. A corporation (if done in the correct state) has no state income tax; no Medicare tax or Social Security tax. A corporation’s owners do not pay individual taxes on all business profits. The owners pay taxes only on profits paid out to them in the form of salaries, bonuses, and dividends. (Dividends are portions of profits that large corporations sometimes pay out to shareholders in return for their investment in the company.) The corporation pays taxes, at special corporate tax rates, on any profits that are left in the company from year to year (called “retained earnings”). However, this taxation scheme does not apply to S corporations, which are corporations that have elected partnership-style taxation. (Regular corporations, discussed above, are called C corporations.) If your corporation elects to be taxed as an S corporation, all of the corporation’s profits and losses will “pass through” to the owners, who will report them on their individual income tax returns.
If an owner of a corporation works for the corporation, that owner is paid a salary, and possibly bonuses, like any other employee. The owner pays taxes on this income just like regular employees, reporting and paying the tax on his or her personal tax return.
The corporation pays taxes on whatever profits are left in the businesses after paying out all salaries, bonuses, overhead, and other expenses. To do this, the corporation files its own tax return, Form 1120, with the IRS and pays taxes at a special corporate tax rate.
RAISING CAPITAL
It can be much easier for a corporation to raise capital than it is for a partnership or sole proprietorship, because the corporation has stocks to sell. Investors can be lured with the prospect of dividends if the corporation makes a profit, avoiding the necessity of taking out loans and paying high interest rates in order to secure capital. However, from a banker’s perspective, a newly formed corporation is a more risky loan applicant than an individual with a home and other assets.