Tax Implications of Incorporating Your Business

Incorporation is a serious step, and it comes with major implications for every aspect of your business — including the taxes you pay. Here’s a closer look at the tax rules and requirements you’ll need to know about once your business becomes a corporation.

How are corporations different?

Incorporating transforms a business into its own legal entity governed by a board of directors. This entity realizes profits and losses independently of you or any other shareholders. Unlike a sole proprietorship or partnership, incorporation shields you and your assets from personal liability. If your company incurs financial or legal liabilities, the corporation itself is held responsible instead. Writing for The Balance, Lahle Wolfe notes that incorporation can involve drawbacks as well. Corporations are expensive to form, and incorporated businesses are required to follow stricter and more complex rules for company structure, operations, and accounting.

Taxation for corporations

Incorporation involves different rules for taxation. Income for non-corporations is taxed on a “pass-through” basis and reported on the owner’s (or owners’) individual tax return. However, corporations are taxed according to a two-step process often referred to as the “double tax.” First, the corporation itself pays corporate taxes on its earnings. According to an article by Julia Kagan for Investopedia, corporations in the United States are currently taxed at a flat 21% rate. After this initial taxation, corporate earnings can be taxed again if they are distributed as dividends to shareholders.

While double taxation can be a drawback of incorporation, corporations are also eligible for a vast array of deductions to reduce taxable income. Per Kagan, expenses that can be deducted include operating expenses, employee salaries and benefits, interest payments, sales and fuel taxes, and much more. Corporations also have a great deal of freedom to defer income and deduct business losses. They can even carry losses forward to reduce taxable income in future years — or back for previous years.

What about S corporations and LLCs?

If you wish to take advantage of incorporation’s liability protections without incurring double taxation, organizing as an S corporation might be a possibility for your business. With an S corporation, profits and losses pass through the company and are claimed on shareholders’ personal tax returns, resulting in one-time taxation. S corporations are subject to certain limitations — for example, they can’t have more than 100 shareholders, must abide by eligibility limits, and can only sell one class of stock.

A limited liability company, or LLC, is another way to ward off some types of liability while avoiding double taxation. Writing for Investopedia, John Edwards observes that an LLC isn’t considered a taxable entity by the IRS. Instead, it’s a liability-limiting arrangement governed by state laws. This means that under an LLC, participants can decide whether to structure the business as a sole proprietorship, a partnership, or a corporation.

Incorporation can significantly change how taxation works for your business. Before — and after — you take this step, it’s wise to consult regularly with tax and accounting professionals to ensure that you’re complying with regulations and making the right financial moves.