Many businesses start out as sole proprietorships or partnerships because they are the simplest to form. That may have been fine when your business first opened its doors, but it pays to check and see if your current legal structure is still a good fit for your business – especially when it comes to tax breaks and personal liability – or whether it’s time to step up to a corporation or limited liability company (LLC).
1. Have your personal assets grown since you started your business?
If you now have a significant amount of personal assets, you may want to consider converting your business’s legal structure to an LLC or corporation. Without the limited liability protection offered by these business forms, your personal assets will be at risk if your business can’t pay off its debts or satisfy court judgments entered against it.
2. Are you thinking about selling stock to investors or issuing employee stock options?
If you’re thinking about raising investment capital by selling stock – or issuing stock options to attract and retain good employees – you would have to first convert your business to a corporation. While it’s true that LLCs can raise capital by selling membership interests, the process of doing this is more cumbersome than issuing stock, particularly if you expect to have multiple investors or want to raise money from the public.
Another benefit of issuing stock is the ability to make gifts of stock to family members as part of an estate plan. You can easily make gifts of corporate shares without giving up management control and, if you do it correctly, you can avoid paying a gift tax.
3. Has your business started to turn a good profit?
If your business is now bringing in some money, you could potentially save income tax dollars by converting your business to a corporation and keeping some of your profits in the corporation each year. The profits left behind would be taxed to the corporation at corporate income tax rates, which are lower than many business owners’ individual income tax rates.
4. Do you want to start providing fringe benefits to yourself or your employees?
Another tax benefit of corporations is that they can deduct the full cost of fringe benefits (like health insurance and reimbursement of medical expenses) that are provided to employees (including owner-employees), and the employees and owner-employees don't have to pay any tax on the value of these benefits. Other types of business entities can also deduct the cost of many fringe benefits as a business expense, but the owner-employees who receive these benefits will ordinarily be taxed on their value.