Should You Incorporate Your Business?
By Matt Dickstein
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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.
Limited 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).
Costs. 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 partnership’s business.
Tax Factors. 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 entities).
Tax 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.
Tax 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.