You Incorporate Your Business?
By Matt Dickstein
If you are a sole
proprietor, you probably ask
yourself, should I form an entity for my business? What are the costs and
benefits of forming an entity versus remaining a sole proprietor?
Answering these questions is
not easy. The answer is different for every business depending on its
circumstances and needs. The answer depends on a balancing of many
different and conflicting factors. Most of us suffer information overload
not long after starting this analysis – all of the factors start swimming around
in our minds and we don’t know what to think.
This article gives you a quick roadmap in
deciding whether or not to form an entity. The first and foremost
consideration is whether you need limited liability. Next you ask, are the
costs of forming and maintaining an entity worth the limited liability protection? Then you determine
whether you will be taking on a partner. Then you delve into the tax
advantages and disadvantages of forming a corporation. Last, you weigh the
factors against one another and make a decision.
Liability. Limited liability is the primary factor in deciding
whether or not to incorporate. A sole proprietor is personally liable for
all debts and liabilities of the
business. On the other hand, a shareholder of a corporation (or member of
an LLC) is not personally liable for the corporation’s
debts (except payroll taxes and for the shareholder’s own negligence and
the negligence of employees under the shareholder’s supervision).
You want the benefits of limited liability. Now you need to ask yourself, is it
worth the price? Limited liability costs money – entities pay franchise taxes
and require higher legal and accounting costs for their organization and
maintenance. In fact, if you want to reduce the analysis to the absolute bare
minimum, answer this question: For you, is limited liability worth the costs of
having an entity?
Partners. If you want a partner, you probably will need to form a
corporation or LLC. Although two or more sole proprietors can work together as
a partnership, this is not your best choice. Partnerships are risky because
each partner is liable for the acts of each other partner in carrying out the
In my experience, the tax analysis
will cause most of your confusion. Worse, in the end you may find that the
various and sundry tax advantages and disadvantages seem to cancel one another
out. For this reason, for the most part, tax should not be a major factor in deciding whether to
incorporate (although tax still is a big factor in choosing between
Advantages of Incorporation. There are few remaining tax benefits for
incorporation. Moreover, what few tax benefits there are work only for “C”
corporations (not for “S” corporations, partnerships or most LLCs). In brief,
forming a “C” corporation helps with fringe benefits (most notably health
insurance) and life insurance. Forming an entity does not do much good
for your retirement plans.
In two limited areas, forming a “C” corporation can
provide some benefit. First, if the applicable corporate tax rate is lower
than your personal tax rate, then incorporating can shift income to the lower
corporate rate. Second, you can defer income tax by selecting a fiscal year.
The bottom line here is to talk with your accountant. If not structured
properly, you run the risk of incurring the dreaded double tax and the 35% flat
tax for personal service corporations.
Disadvantages of Incorporation. As I mentioned above, entities must pay a
franchise tax. California imposes an $800 minimum franchise tax on corporations
and LLCs (except that corporations are exempt from the minimum tax in their
first year of existence). Also, being a sole proprietor has these additional
tax benefits: (i) a sole proprietor can never be taxed as a personal service
corporation; and (ii) a sole proprietor can avoid FUTA, California unemployment
taxes and workers compensation premiums (but not the self-employment tax, i.e.
the social security tax).
This article only gives a short
roadmap of the issues involved in deciding whether or not to incorporate. There
is a lot more to this topic than introduced here. So, before you do anything, get competent legal and accounting help.
me to schedule a legal consultation: