It’s not an uncommon occurrence. A man or woman with a great business idea decides to take the plunge. At first it’s an evenings-and-weekends thing. But as time goes by, it becomes more profitable, and more time-consuming. Pretty soon, the entrepreneur realizes it’s time to quit the day job.

And because it’s been a one-person show, it’s very possible that the founder has never bothered to incorporate. That can be a big mistake. It might seem easy just to keep going as a sole proprietor, but for the long-term security of your business, that can be a risky strategy.

“For most small businesses, especially of the type that has income, assets of any size and the need to designate a single person as president for contact with the public, a corporation is really the best,” says Richard Latta, a lawyer with the firm Michael Best & Friedrich in Madison, Wis. That’s especially true for a business that works in a field that requires a license, is governed by state or federal regulations, or will expose the owner to liability if things go wrong.

Incorporating limits the owner’s legal exposure to the assets of the corporation. It also offers new sources of financing.

A sole proprietor who needs to raise funds has no choice but to borrow money and pay it back with interest. But a corporation can raise capital for expansion and other purposes by selling shares. (Of course, that’s a complex legal process to be undertaken only with professional consultation and following rules and regulations — but it does expand your fundraising options.)

Additionally, the simple act of incorporating can make your business look more serious and improve your creditworthiness to banks you approach for traditional financing.

C, S or LLC?

There are three basic types of corporations. C corporations are the ones we most commonly think of — typically major corporations like General Electric or Exxon. While there may be specific reasons to opt for that structure, small businesses generally don’t.

Instead, they typically become either S corporations or LLCs — limited liability companies. Why? One big reason is that C corporation income is taxed twice: once at the corporate level, and again as personal income when it’s paid to the owner. Income from an S corporation or LLC is only taxed once, at the personal owner/shareholder level, Latta says.

Another advantage to the S corporation or LLC is in how often you have to pay taxes. C corporations typically pay estimated federal income taxes (and state taxes, if they apply) every month. Many LLCs and S corporations, like most unincorporated sole proprietors, pay those taxes every quarter.

Deciding between an S and an LLC is a little more complicated. S corporations have been around a long time; LLCs are relatively new. For the most part, they’re pretty similar, but there are important differences.

The law limits the number of S corporation shareholders to no more than 100 (with limited exceptions for families), and no foreigners, Latta notes. Also, S corporation shares cannot be held by an Individual Retirement Account, says Tom Ochsenschlager, retired vice president of taxation for the American Institute of Certified Public Accountants. Violating any of those or some other rules can lead to disqualification of an S corporation.

However, there may be some uncertainties about how much an LLC actually protects the liability of an individual, Latta says. While S corporations have firmly withstood attempts to “pierce the corporate veil” between the corporation and the shareholder’s personal assets, there are some states in which the strength of the LLC shield “hasn’t been thoroughly tested,” he says.

For that reason, Latta believes the S corporation offers just a bit more security. But that may differ from state to state, so you should always check with knowledgeable financial and legal advisors before taking any steps to incorporate or change your existing corporate structure.

A Caution About Pay — and Taxes

There’s another point about LLCs or S corporations that you may hear about from some advisors. But it requires great caution. Corporations pay out two kinds of income to shareholders. Shareholders who are also officers or employees may get paid in wages or salary. But shareholders also can get paid in the form of dividends.

In the case of S corporations or LLCs, both kinds of income get assessed federal income taxes (and state and local taxes as well, if they apply). Wages and salary, however, are also subject to payroll taxes for Medicare and Social Security (FICA).

Thus, it’s possible for some of your corporate earnings to come to you as wage or salary income, and other earnings, with a lower tax bite as a consequence, as dividends. But if you apply this strategy, you should do it only with the most expert professional advice.

“It is a hot button with the Internal Revenue Service,” Ochsenschlager says. One key test is how much money you’ve invested up front in the business. A dividend, after all, is only to be paid as a return on investment. If your business hasn’t required much in up-front cash out of your own pocket for supplies, inventory or equipment, the taxman is likely to be very skeptical of your attempt to claim a dividend.

Also sure to raise eyebrows at the IRS are artificially low salaries for shareholder-employees who could earn much more for their work out in the job market, and other income claimed as a “dividend.”

“If it turns out you’re working a 40-hour week and only paying yourself $5,000, the IRS will come back and say that’s not right,” Ochsenschlager says. “You should be paying yourself a salary equivalent to what you’d pay someone else to do that same job.”

The Bottom Line

Incorporation of any kind will cost you something — in money and in compliance with the laws of your state and the federal government as they apply to your chosen corporate structure. But the benefits far outweigh any costs in the protection it offers you, experts say.

When you do incorporate, the S corporation is probably your best bet, at least for now. But make sure you understand all the rules that apply to that structure, and follow them strictly. Because the whole reason you’re doing this is for a smoother-running business and peace of mind. And that’s real corporate power.