Timing of Incorporation and Differences with Sole Proprietorships | Explaining the Merits and Demerits
As many business owners continue their business as sole proprietors, the time comes when they wonder, "Should I incorporate (establish a corporation) soon?" While you may have heard that it leads to tax savings, you may also have heard that social insurance and administrative burdens increase, leaving many unsure how to decide.
In this article, we will organize the merits and demerits of incorporation and explain the general timing to start considering incorporation, with concrete examples.
Merits of Incorporation
[Tax Savings Effect Due to Differences in Tax Rates]
Individual income tax has a system where the tax rate increases as income increases, gradually rising from 5% to 45% (Article 89 of the Income Tax Act). On the other hand, corporate tax rates are generally fixed. For small and medium-sized corporations with capital of 100 million yen or less, a reduced tax rate of 15% can be applied to profits of up to 8 million yen per year (temporary measure, Article 66, Paragraph 2 of the Corporation Tax Act, Article 42-3-2 of the Act on Special Measures Concerning Taxation). As income increases, it becomes easier to reduce the tax burden by operating as a corporation rather than an individual.
[Social Insurance Premiums]
Sole proprietors enroll in the National Pension and National Health Insurance, while representatives of corporations enroll in the Employees' Pension Insurance and the Japan Health Insurance Association (Article 3, Paragraph 3, Item 2 of the Health Insurance Act, Article 6, Paragraph 1, Item 2 of the Employees' Pension Insurance Act). Which is more advantageous depends on your annual income and family structure. For example, if you have a spouse you support, you will not incur additional insurance premiums for your spouse under employee insurance (your spouse becomes a third-tier insured person who does not bear insurance premiums. Article 7, Paragraph 1, Item 3 of the National Pension Act). Additionally, social insurance premiums are calculated based on the amount of executive compensation, so it may be possible to reduce premiums by adjusting how the compensation is determined.
[Expanded Scope of Expenses Recognized]
When you incorporate, you are recognized as a legal entity dedicated to business, allowing you to use expenses and benefits that were difficult for sole proprietors to utilize.
① Entertainment Expenses For sole proprietors, entertainment expenses related to business can be expensed without a legal limit (Article 37 of the Income Tax Act). However, it is easier for the tax authorities to question the line between business and private expenses during tax audits. For corporations, small and medium-sized corporations can expense up to 8 million yen per year (or an amount equivalent to 50% of entertainment and dining expenses) (Article 61-4 of the Act on Special Measures Concerning Taxation). While there is a limit, most small and medium-sized businesses fall within this range.
②Employee Benefits Expenses Sole proprietors do not have the concept of "employee benefits expenses" for themselves, and expenses equivalent to living expenses cannot be deducted as business expenses. For corporations, expenses such as health checkups, company trips, and condolence/congratulatory money can be deducted as employee benefits expenses, and recipients are also exempt from taxes within a certain range.
③Company Housing Sole proprietors can deduct as business expenses only the portion of their home used for business. The residential portion cannot be deducted. For corporations, if the company rents a house and lends it to an executive, and the executive pays rent calculated by a fixed formula (Income Tax Basic Notice 36-40), the difference between the actual rent and the calculated rent is not taxed, and the company can deduct it as a business expense.
④Business Trip Allowance (Daily Allowance) Sole proprietors do not have the concept of paying themselves an "allowance," and only actual expenses incurred can be deducted as business expenses. For corporations, by establishing travel expense regulations, a daily allowance for business trips can be paid, which is tax-exempt within a reasonable range (Article 9, Paragraph 1, Item 4 of the Income Tax Act). The difference between the allowance and the actual expenses can also be deducted as a company expense.
【Loss Carryforward Period】
The loss carryforward period is extended from 3 years for sole proprietors (Article 70 of the Income Tax Act) to 10 years for corporations (Article 57 of the Corporation Tax Act). This is particularly effective for tax savings in businesses that tend to incur losses in their early stages or businesses with significant fluctuations in performance.
【Deductibility of Retirement Allowances】
Corporations can deduct retirement allowances for executives as business expenses (Article 34 of the Corporation Tax Act), excluding excessively high amounts, provided that regulations for executive retirement allowances are in place. By aligning the timing of retirement allowance payments with the payout timing of the life insurance mentioned below, tax savings can be achieved regardless of the company's performance at the time of retirement. Recipients also benefit from preferential tax treatment for retirement income (Retirement Income Deduction and 1/2 taxation, Article 30 of the Income Tax Act). Sole proprietors do not have the concept of "retirement allowance" for themselves and can only receive similar preferential treatment through systems like the Small Business Mutual Aid Plan.
【Deductibility of Life Insurance Premiums】
When a corporation takes out life insurance for its executives or employees, a portion of the premiums can be deducted as business expenses depending on the contract (e.g., for endowment insurance where the survivor receives the death benefit and the company receives the maturity benefit, half of the premium can be deducted) (Corporate Tax Basic Notice 9-3-4). Life insurance premiums paid by sole proprietors for themselves cannot be deducted as business expenses, and they can only receive tax benefits through the life insurance premium deduction (up to 120,000 yen, Article 76 of the Income Tax Act).
【Utilization of Consumption Tax Exemption Period】
If you establish a corporation with capital of less than 10 million yen, you can become an exempt business operator for consumption tax for up to two periods (Article 12-2 of the Consumption Tax Act). Even if you have used up your exemption period as a sole proprietor, you may be able to obtain a new exemption period by incorporating. However, due to the impact of the invoice system, it may be better to voluntarily choose to be a taxable business operator, so it is necessary to make a judgment based on the situation.
[Limited Liability]
Shareholders of stock corporations, etc., are not liable beyond the amount of their investment (Company Act, Article 104: "A shareholder's liability shall be limited to the issue price of the shares held by the shareholder."). Even if the business is unsuccessful, you are generally not required to forfeit your personal assets. On the other hand, sole proprietors are infinitely liable for business debts.
[Improved Social Credibility]
Because corporate information is publicly registered and financial statements must be prepared, corporations tend to be more trusted by business partners and financial institutions than sole proprietors. Being a corporation can often be advantageous when developing new business partners or seeking loans.
Disadvantages of Incorporation
[Increased Social Insurance Premiums (if you have employees)]
Sole proprietors are not obligated to enroll their employees in social insurance unless they are in certain industries that regularly employ five or more people. Corporations are generally obligated to enroll employees in social insurance (Health Insurance Act, Article 3, Paragraph 3, Item 2; Employees' Pension Insurance Act, Article 6, Paragraph 1, Item 2). Since premiums are split between the company and the employee, the company's burden increases if it employs staff.
[Corporate Tax Flat Levy]
Corporations are subject to a "flat levy" tax that must be paid even if there is no profit (Local Tax Act, Article 312). The amount varies depending on capital, number of employees, and municipality, but it is a cost unique to corporations that represents a certain burden even when operating at a loss, unlike sole proprietors. Please consult a tax accountant or your local municipality for the exact amount.
[Setup Costs and Maintenance Costs]
Establishing a corporation incurs costs for notarization of articles of incorporation and registration (for stock corporations, actual expenses are generally around 200,000 yen). The registration process is also complex, so it is common to hire a professional. After establishment, accounting and tax filings are generally more complex than for individual tax returns, and ongoing maintenance costs, including tax accountant fees, are incurred.
[Increased Accounting and Administrative Burden]
Corporations are required to maintain formal accounting records using double-entry bookkeeping. They must also establish internal rules such as travel expense policies and salary regulations, and comply with corporate law procedures like shareholder meetings and board of directors meetings. Tax filings also change from income tax to corporate tax, becoming more specialized. Procedures for social insurance and restrictions, such as not being able to freely change executive compensation mid-fiscal year, are additional burdens not faced by sole proprietors.
Guidelines for the timing of incorporation
As mentioned above, incorporation has both advantages and disadvantages. When a business grows in scale, the impact of taxes and social insurance contributions is likely the most significant concern. Let's examine the actual amounts.
[Calculation Example] We will compare taxes and social insurance premiums (for Kenko Hoken, Tokyo) assuming a sole proprietor's taxable income (after various deductions) is 9.5 million yen, with a dependent spouse (full-time homemaker) and one college student child (22 years old). (Deferment systems like the student payment deferral for National Pension are not considered).
| Item | Sole Proprietor | Incorporation (Executive Compensation 9.5 Million Yen) |
|---|---|---|
| Income Tax | 1,599,000 yen | 1,100,500 yen |
| Resident Tax (Estimated 10%) | 950,000 yen | 755,000 yen |
| National Health Insurance Premium (Household Maximum) | 1,130,000 yen | — |
| National Pension Premium (for Self, Spouse, and Child) | 645,120 yen | — |
| Health Insurance Premium (Employee's Share) | — | 467,875 yen |
| Employees' Pension Insurance Premium (Employee's Share) | — | 713,700 yen |
| Total (Employee's Share) | 4,324,120 yen | 3,037,075 yen |
| Health Insurance and Employees' Pension Insurance Premiums (Employer's Share) | — | 1,181,575 yen |
| Total Tax and Social Insurance Burden | 4,324,120 yen | 4,218,650 yen |
In the example above, the burden after incorporation is 4,218,650 yen, compared to 4,324,120 yen for a sole proprietor, resulting in a reduction of 105,470 yen. This is because when comparing receiving income as a sole proprietor versus receiving executive compensation after incorporation, the burden of income tax and resident tax is lighter due to the salary income deduction. Furthermore, in terms of social insurance premiums, a sole proprietor bears the burden for themselves and two others, whereas after incorporation, the spouse and child become dependents, incurring no additional burden.
As a guideline for incorporation, when taxable income (business income after various deductions) generally exceeds 8 to 9 million yen, the cost savings from incorporation tend to become significant. In the example above, the difference in burden is about 100,000 yen, but considering the income amount, family structure, deduction of various expenses, and the design of executive compensation, there are many cases where incorporation is more advantageous.
It is advisable to consider incorporation in line with the current phase of your business, taking into account the burden aspects mentioned above, as well as the following points.
- When it overlaps with the timing of becoming a taxable business operator for consumption tax
- When you are required to have a corporate status due to loans from financial institutions or contracts with large clients
- When you plan to hire employees and expand the scale of your business
Incorporation requires comprehensive judgment. Please feel free to consult us if you would like a specific simulation tailored to your business situation.
For those who wish to know more details, please feel free to contact us. We would also appreciate it if you could take a look at our services and fees.
