There are advantages and disadvantages to incorporation. The decision to incorporate depends primarily on your net income and your level of exposure in the event of a law suit.
As a sole-proprietor, you are the business. What ever happens to the business happens to you and your family as well. If you were to be sued, your personal assets along with the business assets are exposed.
One big reason, a small business will incorporate is with a corporation and somewhat with a LLC, the losses are limited to the investment in the company. If the company owns equipment, then the equipment and any other assets are subject to confiscation in a lawsuit, but as a stockholder your personal home or assets are not (if there is no co-mingling of funds).
The exception of this, is trust fund taxes. Taxes held from an employee’s paycheck and not given to the IRS remain the liability of the officer in charge personally and may not be bankrupted off.
Tax Benefits of Incorporating
The other major determination is your net income. As the owner, you must earn a reasonable wage. In a corporation, the remaining income is passive income and not subject to self-employment tax which is your Social Security and Medicare contribution. As a sole-proprietor, all your income up to the limits is subject to SE tax. Let’s look at an example:
Sole Proprietorship: $100,000 Net income*
$15,338.40 Self Employment tax
S-Corporation: $100,000 Net Income
$7,700 Self-Employment tax
$50,000 Passive income with not SE tax
*Net Income = Gross receipts – all business expenses.
Net taxable income on 1040 for federal taxes:
Sole Proprietorship: $100,000
S-Corporation: $100,000 ($50,000 Salary + $50,000 passive income K1)
The Taxable income for Federal taxes are the same, but the taxes are not. Of course, the less amount of Social Security and Medicare you contribute over your lifetime will affect your retirement benefit.
Total tax savings from incorporation $15,338.40 – $7,700 = $7,638.40
Disadvantages of Incorporating
Now the bad news, with a corporation comes more responsibility:
-Must pay yourself payroll which will require a professional service
-Must have a formal set of books such as Quickbooks
-Must have a separate bank account and
-Cannot co-mingle funds
-Yearly corporate board meetings and minutes
One further benefit of incorporating is the majority of all audits (approx. 65%) are on the Schedule C (sole-Proprietorship); less than 3% of audits are on corporations. If your net income does not exceed $50,000, I generally recommend getting Liability and E&O insurance and remaining a sole proprietorship. The extra cost and requirements do not out way the benefits
Please talk to your professional tax preparer for specific guidance with your decision.