Should You Incorporate Your Business?
Home-based computing and the ability for people to easily communicate globally has led many to consider home-based businesses or work as independent contractors. A majority of these ventures are legitimate establishments that are best managed as corporate entities.
Becoming a corporate businesses allows home-based businesses to take advantage of benefits originally designed for larger companies. Even small businesses, such as those that produce incomes around $50,000 (or, in Canada, anything over $30,000), can benefit from incorporation. Incorporation can build legitimacy for a business and its services.Compared to being a sole proprietor, incorporation also provides benefits by reducing personal liability or income taxes.
The reduction of personal liability or taxes is achieved by incorporating as a limited liability company (LLC) or as an S-corporation (S-corp). In this article, we’ll take a look at these two corporations and show you how to determine which is most appropriate for your company.
Limited Liability Company (LLC)
LLCs mitigate the financial liability of their owners by limiting the financial liability to only the corporate assets. Conducting business can be highly litigious. The advantage to the owners and employees is that only the corporate entity is held liable for its business actions. But just because independent contractors and sole proprietors may work for a larger concern, doesn’t mean that the company will indemnify them from legal issues arising from their actions if they aren’t employees. Unless specifically contracted in writing, many independents can be held responsible for legal issues arising from their labors.
For example, multi-level marketing companies (MLMs) may put a significant number of individuals at risk. MLMs tend to forgo a sales department by allowing contractors to act as distribution channels. By advocating the consumption of products and services to consumers, these independent contractors may be subject to lawsuits if the service providers are found negligent and injure their customers.
If an independent contractor or sole proprietor becomes an LLC, the individual’s liability is limited, which often puts the owner’s personal assets out of harm’s way. Small business owners are least able to overcome the loss of any personal assets and therefore have the most to gain from structuring their businesses as an LLC. Individuals who may be taking on personal liability because of their affiliation to another related business should consider restructuring their business as an LLC to shield themselves from financial losses to their personal savings. Business owners who, as a normal course of business, create a potential risk of injury to themselves or others should purchase business or personal liability insurance in addition to sheltering their assets with the LLC.
In most situations, the LLC’s business profits flow through to the individual members, allowing it to avoid the double taxation of paying corporate tax and individual tax. This can be a tax advantage over traditional corporate structures, but compare the corporate tax rate for a business of your size with your personal tax rate, to see which tax rate would be better for you.
LLCs also have much greater flexibility in how they are organized and managed; they can issue a variety of classes of stock (S-corps can have only one class), have more than 100 shareholders, and shareholders can include nonresident aliens, a category not permitted to an S-corporation. For more, see The Basics of Forming a Limited Liability Corporation.
By incorporating your business as an S-corporation, you also protect yourself against being personally liable for corporate debts. As with an LLC, your personal assets cannot be seized to repay liabilities of your S-corporation. Similarly, the S-corporation cannot be held liable for judgments against you personally. (See Understanding S Corporations.)
Being an S-corporation can reduce the impact of self-employment tax depending on the difference between the amount that the business makes by providing a service and the amount that would normally be paid to an employee for providing the same. This self-employment tax (SE Tax) covers anyone who engages in a business or trade to earn his or her livelihood or a profit and has not created a corporation to do so.
Sole proprietors who provide full- or part-time services such as independent contractors, farmers and some government officials, will incur this tax. Had they been an employee, their employer would have deducted the requisite Social Security tax from an employee’s paycheck, matched that amount and then sent the total tax payment to the IRS. The self-employed report their earned income and pay the equivalent taxes (the employee share plus the employer share) directly to IRS. These taxes are a significant portion of all the tax incurred by sole proprietors or independent contractors.
According to the IRS, self-employment tax for 2016 is 15.3%. The rate consists of two parts: 12.4% for Social Security and 2.9% for Medicare. Only the first $118,500 (this value is periodically adjusted) of combined wages, tips and net earnings is subject to any combination of the 12.4% Social Security part of self-employed tax.
Example – Incorporation and Tax Benefits
Let’s take a look at a sole proprietor who makes $125,000 for providing a particular service. She would pay 12.4% on the first $118,500 and then 2.9% on the entire $125,000 for a total of $18,319. As an S-corporation, she could reduce the impact of self-employment taxes, because she could pay herself a salary equal to the salary paid by an employer. Deriving the appropriate salary is a gray area and can be subject to IRS scrutiny, but the advantage can be significant.
The same individual, who makes $125,000 from her business, determines that a person doing the same job for an employer makes $40,000 per year. As the owner of an S-corp, this individual could pay herself a salary of $30,000 and only pay self-employment taxes on this figure – which would equate to roughly $6,120, thus reducing the overall tax liability by $12,199. While the entire $125,000 is subject to normal income taxes, the $85,000 is sheltered from self-employment taxes.
Note: Shareholders receiving any income from the corporation are also subject to normal income taxes on corporate distributions and dividends.
There are additional strategies that S-corporations can use to reduce income tax expenses. Distributions from an S-corporation are not subject to FICA taxes. Cash distributions and dividends are subject to ordinary income taxes, but still save the 15.3% that would normally have been assessed if paid as wages. Owners should ask tax professionals about the variety of alternate methods for withdrawing income from an S-corp that would result in the reduction of self employment taxes.
There are many intangible benefits that are achieved through incorporation.
- Corporate entities that create a market identity for themselves and their products through name recognition and brand identity are often better regarded by consumers and market participants than independent contractors.
- Corporations also last beyond the original owner. When the main contributor to a small business is unable to perform his or her duties, these businesses ultimately fail. Sole proprietorships tend to underscore this risk and impede a business’s reputation as an ongoing entity.
- Corporate entities can apply to and receive funding more easily than sole proprietors. Sole proprietorships can find it hard to raise capital because institutions look to the net worth and creditworthiness of the individual when deciding to provide financing. Investors and customers prefer to deal with entities that are perceived to have long-term potential. Small business lenders using strict underwriting criteria find it easier to make more competitive loans when they feel that the business has entity-level value that can be sold or that ownership can be transferred. Investors want to be assured that ownership will continue to be valuable even when the principal contributor to the business no longer manages the business.
Drawbacks of Incorporation
The drawbacks for LLCs and S-corps are similar to those of partnerships.
- In some circumstances, LLCs may have difficulty in raising equity capital and using debt capital as a main source of financing. Although the economic interest in an LLC is transferable, the right to vote and participate in the management of the business can be difficult to execute. Providers of equity or debt capital may shy away from infusing capital where they cannot gain managerial control in the event of default or low performance.
- Some states put conditions on corporate structure, in some cases requiring the LLC to dissolve once all members have withdrawn. These problems can be circumvented by incorporating in another state.
- S-corporations are more difficult to form and maintain because they require the same governance structure as a regular corporation. Articles of incorporation must be filed with the state, bylaws need to be developed and stock has to be issued.
- Corporations must have their own financial accounts and file the names of all officers with the state. Like corporations, a board of directors is established and it is this board that makes managerial decisions.
- An S-corp can only have one type of stock limited to no more than 100 shareholders, and states limit the types of businesses that can become an S-corp. As mentioned above, shareholders can not be nonresident aliens.
The Bottom Line
Whether one chooses an LLC or an S-corporation, some corporate structure is better than being a sole proprietor or independent contractor. Home businesses that continue to be managed as sole proprietorships may miss out on benefits that can easily be achieved by following relatively simple procedures and corporate governance. The opportunity to enhance a business’s standing in the eyes of the marketplace provides a boost to its longevity that is hard to create as an independent contractor or one-man shop. In some cases, consumers might not perceive a small corporation any differently than ones with millions in revenue.
Therefore, incorporating one’s business can provide a potential boost to business growth that is much more difficult to achieve without it. To receive these benefits, certain paperwork must be filed regularly and more rules must be followed than required for mom-and-pop companies, so make sure you are ready to jump in with both feet when you choose to incorporate. Then consult carefully with your financial advisors to decide which structure would be the most beneficial for your business. For more, read S Corp. vs. LLC: Which Should I Choose?
This article was originally published at Investopedia.com.