To Incoporate or Not
Should I Start Off As a Corporation? The Answers Vary An a Number Of Factors.
This is the simplest form or entity around. There are no federal or state unemployment taxes, there are no double tax problem, no stock holder meetings, no employment number required from the IRS unless you have employees, and the form that is required by the IRS is the schedule C on your income tax return that your filing anyways. As a sole proprietorship, you also have the advantage of being the best entity to use any losses incurred. If you have losses in your business, which is usually the case for the first year or two, these losses can be used against any form of income on your tax return such as wages, interest, dividends, pensions, rents, etc. If the loss exceeds your income, you can carry back all business losses two years or carry forward business losses twenty years and offset the next twenty years of income. These are all good advantages, but probably the major drawback is liability. Any sole proprietorship has unlimited liability in their business.
Big Tip:If you have employees, you have substantial liability because all employers are liable for acts of their employees and little liability such as that found with most multi level businesses, this might well be the entity of choice.
Next level of complexity is a partnerships, this involves two or more people who are sharing profits in a venture. In this case you are required to file a partnerships tax return. You will need a federal ID number from the IRS and be subject to federal and state tax on salaries. Partnerships are pass through entities as sole proprietors. There is no separate tax at the partnerships level and all income and losses pass through the partners as if they earned them individually.
Is that you are unlimitedly liable for partnerships debts and for the acts of your partner. This is a major disadvantage.
Regular C Corporation:
Corporations are separate entities that requier their own tac return to be filed (IRS for 1120). They are taxed on all monies that are not paid out in expenses or bonuses or salaries. If the funds are paid out again in dividends, you could be taxed again. There is a potential of double taxation. Based on the complexity and formalities involved, they are the biggest headache of them all. You must have a yearly stockholder's meeting even if you are the only stockholder. You will need to hold annual board of directors meeting, you must have separate bank accounts, you must have an Employer ID number from both the IRS and the state. In California, you pay the normal tax rate of $800 or whichever is higher. If you have a loss, you still pay $800. However, Corporations do have advantages. You can deduct 100% of your health insurance premiums and 100% of any disability premiums, which are tax-free benefits to the employees. The main advantage is limited liability. If you maintain the formalities, your liabilities are generally limited to the assets of the corporation with the exception of malpractice suits. In malpractice, the owners may be unconditionally liable regardless of the entity.
Because liability protection is so important in the decision on whether to incorporate, I almost always recommend some form of corporation or LLC if there are employees in the business. As noted above, employers are liable for the acts of their employees: this, employees are walking liability machines. If you have any employees, you must limit your liability.
The main advantage is that they generally are not subject to double taxation. All income and losses flow through to the owners: thus, eliminating most of the double taxation problem. S corporations also limit liability just like regular corporations and are subject to the same formality requirements. They also have two other major advantages: First, the stockholders are taxed on the earnings based on their ownership. Thus, you can have a 17 year old son or daughter taxed on their share of dividends. Second, how would you like to eliminate some of your social security taxes? You can with a S corporation. With all these advantages, one would think that a S corporation would be the ideal entity. However, there are some limitations and disadvantages. There can be no more than 75 stockholders who, for the most part, must be individuals. Moreover, S corporations can't have several classes of stock; this, limiting estate planning and reducing the chances of raising capital. S corporations have the same formalities as regular corporations and the same paper work and meeting hassles. Certain fringe benefits are not available to S corporations as they are to regular corporations and even sole proprietorships with some planning such as a self-insured medical plan. You can deduct any health insurance premiums with an S corporation. Regular corporation can deduct 100% of the premium, and sole proprietors can also deduct 100% if they hire their spouse in their business. Regular corporations can deduct all of their disability insurance premiums; S corporation cannot.
One final item to note is that with both S corporation and partnerships, you can deduct any losses up to your basis in the stock or partnerships. However, with partnerships, any debt that you guarantee is added to your basis. This is NOT true with S corporations. You must contribute property, money or load the money to the corporation, not guarantee a debt.
Limited Liability Companies (LLC):
This is the newest addition to the business party, being a fairly innovation. This is like a sole proprietor or partnership, however, there is limited liability like that of a corporation. If there is only one owner, you would file and taxed as a sole proprietorships. If there are two or more owners, you are taxed as a partnerships. LLC's work well to both limit liability and not have the formalities of corporation ownerships.
One final point I share before you decide where to incorporate is if you ask five accountants, you will get five different answers. Nevada is a popular state of this matter. Contrary to what most people will tell you, this will not save you taxes. However, Nevada has strong laws against, piercing the corporation for liability protection. In addition, there are some extra privacy considerations available in Nevada that most other states.
One big issue that involves multiple owners of a corporation of LLC is what happens if you and one other owner of your corporation do not get along? The result has been some of the most expensive and protracted legal battles around. It is worse than a divorce. Thus, a big, big tip is that if you are incorporated or have an LLC and have co-owners, always set a buy-sell agreement at the start. This will eliminate a lot of problems. You will be grateful, I guarantee it. In short, the way you start up your business can protect you from liabilities and make your life a lot less taxing!