Benefit One: Limited Liability
The big legal benefit that corporations provide business owners with is liability protection. What this means, practically speaking, is that the business owners are not liable for the debts of the business merely by virtue of their ownership.

However, to best understand what this limited liability protection means, you need to consider the situation that exists with respect to businesses that are un-incorporated.

In a sole proprietorship, for example, the proprietor is responsible for all the debts of the business. If the business signs a contract with some customer or vendor and then breaches the contract, or if the business fails to deliver on a financial promise made to some employee, the owner is liable.

A business organized as a general partnership works the same way. If the business breaches a contract, or makes and then breaks a financial promise, the partners in the partnership are liable.

In comparison, with a corporation, an owner (called a stockholder or shareholder) is not held liable.
Consider what this means for a small business. In a worst case scenario, outside creditors (these outside creditors would obviously include people such as the bank and vendors but might also include other people or organizations that you owe money to, such as customers and employees) might be able to strip the corporation of all its assets to pay a debt or force the corporation to liquidate to pay its debts. But these outside creditors would not be able to look to the corporation’s owners for repayment merely because they own the corporation. Therefore, the legal liability protection provided by a corporation can be extremely valuable.

If you’re concerned about the asset protection features of setting up and operating a corporation, get an attorney involved in your business or investment planning regularly. An attorney knowledgeable in business law can help you increase the liability protection that you gain from using a corporation for your business or investing.

Benefit Two: Potential Tax Savings
A second benefit of corporations relates to the income and payroll taxes that a business pays or that investors pay. As a general rule, small business corporations provide two tax benefits to their owners.

The first potential tax saving associated with incorporating your business applies to what the tax laws call a C corporation. A C corporation (but not an S corporation which will be discussed next) can typically provide tax-free fringe benefits to all of its employees.

In other words, the corporation can provide benefits such as medical insurance, reimbursement of medical expenses, a modest amount of life insurance, employee housing (in some cases), and so on. And this is true even if the only employee is a shareholder.

The cost of these benefits generally counts as business deductions for the corporation as long as the corporation doesn’t discriminate in favor of shareholders and as long as the expenses are “ordinary and necessary” business expenses or expressly authorized as deductions by tax laws. But—and here’s the neat thing—the deductions aren’t taxed to employees.

Tax-free fringe benefits, then, allow a small corporation’s owners to enjoy some of their business profits tax-free. In a situation where a one-employee-one-shareholder corporation provides full health benefits and housing to its single shareholder-employee, the corporation might be providing $20,000 or $30,000 a year in tax-free fringe benefits to that employee.

Yet those benefits, while allowing tax deductions for the corporation, would not be taxable to the employee. And this would mean that the annual tax savings would very likely run between $5,000 and $10,000 each year.

A corporation also affords its owners a second potential tax saving opportunity, Subchapter S status. To understand this benefit, though, you need to understand a thing or two about the payroll taxes that self-employed people (like sole proprietors and partners in partnerships) pay and that regular C corporations and their employees pay.

In a nutshell, money that a business owner makes in an active trade or business is not subject just to income taxes. In addition to income tax, each business owner also pays an employment tax equal to roughly 15% on the first $100,000 of profit and then roughly 3% on any profit above $100,000.

In the case of a sole proprietorship or partners in a partnership, the employment taxes are called self-employment taxes. In the case of a shareholder-employee in a corporation, the employment taxes are called Social Security and Medicare taxes.

To show you how the employment taxes work, suppose a sole proprietor, a partner in a partnership, or a single shareholder in a regular corporation (called a C corporation by tax laws) makes $200,000 in a year.

This proprietor or partner will pay roughly $15,000 in tax on the first $100,000 of business profit, and he or she will pay roughly $3,000 on the second $100,000 of profit.

If the single shareholder-employee extracts all of the $200,000 in corporate profit as salary—and this would probably be the most common approach for a small business—the shareholder (either directly or indirectly) also pays roughly $15,000 in tax on the first $100,000 of business profit and $3,000 on the second $100,000 of profit.

In all three of these cases, the business owner pays roughly $18,000 of employment taxes. Again, note that these employment taxes are in addition to the income taxes he or she pays on the $200,000 of business profit. (Those income taxes probably total another $30,000 or $40,000.)

Things work differently if the corporation elects to be treated as a Subchapter S, or S corporation. In this case, the corporation probably sets the shareholder-employee’s wages to a low but reasonable level. Perhaps this means wages equal to $60,000 annually. In this case, the employment tax equals 15% of only the $60,000 in wages, or $9,000.

As compared to the case where the same business makes $200,000 a year but is operated as a sole proprietorship, a partnership or a C corporation, an S corporation saves the shareholder-employee roughly $9,000 annually.

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