Why you should incorporate your business

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(FORTUNE Small Business) -- Dear FSB: I've been in business for seven years now. I'm a sole proprietor and I have an SBA loan from 2002. My question: Is it better to incorporate now, or wait? How will incorporation protect my personal assets if my business fails?

- Mary Ebsen, Mayer, Minn.

Dear Mary: The legal form for your business is crucial to shielding personal assets from business liabilities. In addition to the corporation, you should also consider other legal forms such as a limited liability company (LLC).

The nature of your business, annual revenue, size and number of employees are factors that will determine which structure is best.

Forming a corporation is more complicated and costly than forming an LLC. It requires that you create a board of directors, and is less flexible than an LLC from a tax perspective.

By contrast, the administrative requirements for an LLC are relatively simple: You must sign an operating agreement, file an annual tax return and keep a separate bank account for your business.

For a discussion of the forms available in Minnesota and the tax and non-tax considerations for your state, download a copy of A Guide To Starting a Business in Minnesota or call 651-556-8425.

The SBA runs technical assistance centers where entrepreneurs may receive free counseling about incorporation and many other business issues. These centers are the Women's Business Centers, SCORE and the Small Business Development Centers.

The LLC is often a logical choice for sole proprietors like you. As an LLC you will still be taxed as a sole proprietor, but your business will be a separate legal entity. And you can't be held personally liable if your company breeches a contract.

One key exception: If you run a personal service business (such as a daycare center), creating a separate legal entity may not protect your assets from damages to others that resulted from your personal services, says Carl Peterson, CPA and Minnesota Society of CPA board member.

Along with liability factors, you also need to consider how forming a corporation or LLC will affect your tax structure.

"The LLC is a chameleon for tax purposes," says CPA Steve Nelson. "The owner is still taxed as a sole proprietor, but might want to consider applying for S corporation status."

S corporation status is not a legal business form, but a tax classification. An LLC cannot limit its payroll tax liability while an S corporation can.

You save because the owner of an S corporation may withdraw part of the company's income as wages and part as distribution, says Peterson. The wage amount is subject to payroll taxes of 15.3%, while the distribution amount is not subject to payroll taxes.

Let's say your business posts annual revenues of $100,000. As an LLC without S corporation status, that entire amount would be taxed. But if you were incorporated as an LLC with S corporation status and took out $30,000 for wages, the remaining $70,000 would not be taxed.

As an LLC with S corporation status, you will need to file an annual federal and state business tax return and you will also need to determine the appropriate amount of payroll for yourself.

"It is important for a small business owner to discuss these issues with a tax professional or a CPA who has experience and can help her discern what may fit her business goals and personality," says Peterson.