A common question amongst Digital Nomads is ‘When should I set up a corporation instead of working as a sole proprietor?’
In order to be able to answer this question, we need to weigh all advantages and disadvantages of setting up a corporation as opposed to run a business from a sole proprietorship.
Sole proprietorship and corporations are by far the most common business structures for freelancers, location independent workers, entrepreneurs and Digital Nomads.
In fact, if you start a business and you are making money by invoicing your clients you will by default be classified as a sole proprietor unless you take formal steps to incorporate your business which will then result in a corporation.
SOLE PROPRIETORSHIP
Sole Proprietorship means that you and the business are the one and the same. This is true from a legal and tax point of view. It basically means that business profits and losses pass through to your (the owner’s) personal tax return and you will have to pay taxes on that income.
The advantages of running your business as a sole proprietor are that it is one of the simplest and least expensive business structures. As stated above, if you don’t take any actions to formally set up a corporation, you’ll be deemed a sole proprietor.
In some countries, you might have to get registered as a sole proprietor and get a registration number, but that’s about it. Further, you will be in complete control of your business and there isn’t an additional tax return that you will have to lodge.
The big disadvantage of a sole proprietorship is that you are personally liable for all business activities. This means that there is no legal separation between you and the business.
Therefore, if someone should decide to sue your business and they win, that they could potentially take all your personal assets (including your home, car, personal bank account, etc.)
CORPORATION
If the disadvantages of a sole proprietorship, make you nervous then you might be better off organizing your business as a registered corporation.
Having a corporation will protect your personal assets in the unlikely event that your business faces a lawsuit or bankruptcy. Even if you’re the only owner of the business and have no employees, you can set up a single-person corporation.
A corporation is a separate legal entity from you and offers limited liability, which is one of the biggest advantages of a corporation. This means that if someone sues your business, they are limited to collect only from the business’ assets and your personal assets remain safe.
Besides the added legal protection that a corporation offers, another benefit might be that a corporation tends to be taken more seriously especially when dealing with outsiders such as potential investors, suppliers, and clients. A corporation will also be taxed separately and can oftentimes access more tax benefits than a sole proprietorship.
However, one of the biggest disadvantages of a corporation is that the formal setup process can take up time and will be more expensive than that of a sole proprietorship.
Also, running a corporation can be a bit more time-consuming as you’ll have to make sure that your business and personal finances are separate which means you’ll need a business bank account.
This is important to ensure that you’ve got that legal protection in case someone decides to go after you.
So, how do you know when it is time to set up a corporation? Below we’ve listed a couple of factors that might help you when making up your mind whether to set up a separate business entity or not.
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SIGNS THAT YOU ARE READY TO INCORPORATE A COMPANY
#1 You start making regular and more money
When you are starting out your Digital Nomad journey oftentimes, you start with a little number of clients and you are just making enough to cover your daily costs. If that is the case, a sole proprietorship is adequate.
However, as soon as you start generating more income and your business is able to provide you with a bit of extra money in your bank account – that is when you might want to start thinking about formally setting up a corporation.
So, as soon as your initial project, side-hustle or hobby starts bringing in regular and steadily increasing income on which you can rely on, that is when it’s time to set up your corporation.
#2 You want to hire people
You can hire people both as a sole proprietor and as a corporation.
However, hiring people means that you’ll have much more responsibilities which include administrative things such as making sure that you get your employee’s tax identification number and social security number, making sure that you comply with guidelines and that you withhold correct amounts from every pay check for taxing obligations.
You might also have additional obligations such as having to pay for worker’s compensation.
You quickly realize that there are many obligations and this means that there are also more opportunities to mess it all up.
The more complicated it gets, the more you will want to protect yourself. That’s why as soon as you are starting to think about hiring people who could potentially sue you, you should make sure that you protect your personal assets by establishing a corporation.
With a corporation in place, employees can only seek recovery from the corporation’s assets.
#3 You want to save taxes
Another valid reason for wanting to set up a corporation is to access certain tax benefits.
We’ve discussed before that sole proprietorships are the same as you. This means, that if you run your business through a sole proprietorship, all your income will be taxed at your personal income tax rate.
By contrast, if you set up a corporation the corporation will lodge a separate tax return to your personal one and will be taxed at the current corporate tax rate.
Tax rates are oftentimes lower than personal income tax rates which means you have to give less to the government if you run your business through a corporation.
Also, in many countries, if you run your business as a sole proprietorship you have to pay self-employment taxes which are likely to include your own Social Security contributions and potentially Medical Care taxes on all of the business’ income.
With a corporation, you only have to pay these taxes on the salary that you pay yourself.
Lastly, many countries even have lower tax rates for small corporations and grants available to new start-ups through which you could receive further tax benefits.
#4 You want to attract big clients
If you’re hoping to land a big client or you are working together with big companies, you have to keep in mind that they prefer to work with corporations.
To put it simply, a corporation makes your business more attractive to prospective clients. Oftentimes large companies won’t even consider working together with you unless you are a corporation.
On the other side, you also have to consider that working together with large companies might expose you to more risk as those companies would have the money to potentially sue you if you don’t comply with certain agreements.
As such, you definitely want to make sure that you have a corporation that will protect your personal assets.
#5 You need to raise money
Oftentimes when your small business starts growing, you might need a business loan from the bank or money from investors. In both cases, whether you are dealing with the bank or with private investors, they both prefer working with corporations.
Corporations are in fact less likely to default on loans and have higher success rates compared to a sole proprietorship. Corporations also present the potential lender with the lowest risk.
That’s why this could be the appropriate time to start thinking about setting up a corporation in order to create more credibility and trust around your business.
Whatever your reason may be for wanting to set up a corporation we are able to help you with the formal process of incorporating a business.
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NOTICE: The content of this article is not to be considered as a legal opinion or tax advice. Wanderers Wealth does not hold itself out as a legal or tax advisor. If you want to receive a legal opinion or tax advice on the matter in this article please contact us directly and we will refer you to a legal practitioner.
