Business owners incorporate to protect themselves from unlimited personal liability for their business. But the tax benefits are not always clear
I am a sole proprietor working as a 1099 commission-only consultant. I make between $150,000 and $200,000 annually and have had to pay as much as $30,000 in income taxes. If I incorporate, would it lower my tax bill?
—T.R., Long Beach, Calif.
Incorporation is a complex issue and there are so many variables that it is difficult to answer your question without getting many more details about your company. This is a situation you should discuss with an accountant who is privy to your financial records, and who can lay out the pros and cons for you based on those specifics, to enable you to make an informed decision.
Generally, however, most companies won't find significant tax advantages to be gained by incorporating. "The marginal tax rates for corporations with taxable incomes between $75,000 and $335,000 are actually higher than the marginal tax rates for an individual with equivalent earnings," says Mark T. Nash, a partner based in Dallas in the PricewaterhouseCoopers' private company services practice. "Assuming you withdrew most or all of the earnings from the corporation as salary, the income would be taxed to you personally in any case."
James O'Connor, tax manager at AVZ, an accounting firm based in Hauppauge, N.Y., agrees. "Merely incorporating, without doing anything more, usually will not achieve any savings. Regular corporate earnings are generally subject to two levels of taxation—once at the corporate level, and again when the net earnings are withdrawn from the corporation by the shareholder," he says.
Assuming you are a U.S. citizen or legal resident, your corporation can elect "S" status or you can form an LLC, which generally eliminates the corporate tax. But in that case, you'll be taxed directly on your company's earnings, which is the same situation you're in now as a sole proprietor.
The one area where you might realize some savings is in self-employment taxes, O'Connor says. "While 100% of your sole proprietorship earnings are currently subject to self-employment tax, a savings may be achieved because the S-corp's net earnings are not subject to self-employment taxes." The S-corp must pay you a reasonable salary, which will be subject to FICA (payroll taxes) at your current self-employment tax rate. However, the S-corp profits—net of your salary—are not subject to self-employment tax, so your corporation won't pay them on its earnings.
Adding Up Costs and Savings
The problem you'll run into, however, is that incorporating is costly. You'll typically have to pay $1,000 or more in the first year to have an attorney set up your corporation and file the appropriate forms for you. In subsequent years, you may be required to pay several hundred dollars in state fees to keep your corporate status up to date, and attorney's fees to keep your minutes current. Accounting fees are also higher if you incorporate.
Another problem is that—as a consultant—your corporation would likely be classified as a personal service corporation, says Nash, "Personal service corporations are taxed at a flat rate of 35%. Individuals operating as sole proprietorships do not reach the 35% marginal tax rate until income exceeds $336,000." Talk to your accountant about whether the additional costs that go along with incorporating might be offset by potential self-employment tax savings.
Deductible Medical Costs
The primary reason many businesses incorporate is to provide the owner with some protection from unlimited personal liability for the acts of the business. As a sole proprietor, you are ultimately financially responsible if your business is sued and damages are awarded. A corporation or, in some states, a single-member, limited liability company, would provide limited liability for you in case you are sued. This is another issue to bring up with your accountant and your attorney.
Finally, ask about medical costs. If you have substantial unreimbursed medical costs, you might be able to deduct them if you form a C-corp, says Leo Bruette, tax partner in the Washington (DC) office of BDO Seidman, a national tax consultancy. "If using a C-corp, there could be a medical reimbursement plan used that would likely make those medical costs deductible," he says.