When You Should Not Incorporate a Business

Incorporating a business delivers benefits. Liability gets limited at least a little bit. And incorporating usually means the business reduces its income taxes or the payroll taxes or both.

But incorporating creates some extra costs and headaches. And some business owners--in spite of the benefits--probably should not incorporate. Consider these risks and headaches:

Headache #1: Payroll

If you currently operate your business as a sole proprietorship and you're the only worker, or you partner with one or more people and only the partners work in the business, you don't have to deal with employee payroll.

When you incorporate--even if you or you and your partner are the only employees--you do have to do employee payroll. Which is a headache.

Payroll processing costs money. You need to regularly prepare payroll checks and deposits. You also need to prepare quarterly payroll reports for Social Security, Medicare, state unemployment and workers compensation insurance. And you need to prepare annual payroll reports like W-2s for employees and the annual federal unemployment tax return.

In some cases, you will also increase the payroll taxes you have to pay simply because you've recategorized a sole proprietor or partner as an owner-employee.

The headache of payroll means you need to be cautious about incorporating a one-man business or a business staffed by its partners. The time and money required for payroll processing easily adds up to a thousand dollars a year or more--which may eat away the tax savings that come from incorporating. Bummer.

Headache #2: More Complicated Accounting and Taxes

Incorporating also creates a second and related-to-payroll processing headache: Incorporation means that the business requires more complicated tax accounting.

A sole proprietor reports his or her income and deductions one the 1040 tax return using a simple one page form--the Schedule C.

A corporation, in comparison, actually requires a separate tax return for both federal and state income tax purposes. The returns can easily ten or twenty pages--which means the returns require much more work to prepare.

A corporation tax return also requires more tax law knowledge--which usually means the small business owner can't do the tax return him- or herself. The small corporation usually requires a certified public accountant or enrolled agent to prepare the tax return. And that's not cheap. A combined federal and state corporation income tax return can easily cost $1,000 or more when all is said and done.

Headache #3: State Registrations and Related Red-tape

One other incorporation headache must be considered by small businesses considering the corporation option--the darn paperwork.

Incorporating absolutely triggers a substantial amount of paperwork and related fiddle-faddling. On an annual basis, the states in which the corporation operates also require annual re-registration. In addition, corporations usually require their shareholders, directors and officers to conduct regular meetings and to maintain detailed records of the items discussed at these meetings.

The work of registering and then annually re-registering coupled with the extra organizational busywork mean that a business owner shouldn't incorporate a business unless he or she can confidently keep up with the study flow of paperwork.

Summing Things Up

Can incorporation save your business taxes? Does incorporation reduce your business liability? A resounding "yes" answers both questions.

However, the tax saving and the liability protection costs you at least one to two thousand dollars a year in extra taxes. What's more, you will certainly have more paperwork to deal with.

In many cases, very small businesses--such as part-time, hobby and home-based businesses--will not be able to economically justify incorporation.