Business Law

Should You Incorporate?

There are a number of forms of business organization. Your choice of a form of organization depends on the size of your operation, and how you decide to pay your taxes. The following forms of organization are discussed in this short piece.

Sole proprietorship
Partnership
C corporation
S corporation
Limited Liability Company (LLC)

SOLE PROPRIETORSHIP

A sole proprietorship is a one person company. The proprietor reports his or her profits on Form 1040 (the individual tax return, using Schedule C. Schedule C lists 27 categories of deductible expenses, and allows you to add “other expense” if some of your costs do not fit the printed “pigeonholes.” Here is the kicker. A sole proprietor is responsible for his or her own Social Security and Medicare tax. Download and take a look at Schedule SE, where you figure your Self-Employment Tax. The form provides an eloquent testament to the need for tax simplification. The “Self-Employment Tax” is added to your tax bill on Form 1040, under “additional taxes” on the back of Form 1040. However, you can deduct half of it on the front of the return in computing your “Adjusted Gross Income.” Clear so far? Right.

The whole thing amounts to a bit more than half the combined Social Security and Medicare taxes paid by employers and employees. As a sole proprietor, you are required to pay into the US Treasury a self-employment tax, with no indication that it will ever go to the Department of Health and Human Services to fund old-age benefits or Medicare costs. Not only that, as an individual owner, you and your assets are vulnerable to public liability should you or one of your employees be at fault in an accident resulting in injury or property damage to another. Liability insurance may not be enough. Also, your profits as a proprietor will be taxed at your federal marginal rate (your top personal bracket). We do not recommend that you remain as a sole proprietor.

PARTNERSHIP

A partnership requires two entities, usually two individuals. A partnership divides the profits between the partners according to their percentage of ownership usually measured by the amount of money they put up to form or join the firm. In many cases, the partners divide the profits in equal shares. A partnership reports to IRS on Form 1065, and passes through its profits to the partners, who report their respective share of profits on their individual tax returns. If the partnership is found liable on a contract or an accident, and if partnership assets are not enough to pay the claim, partners may face individual liability. Again, liability insurance may not be enough.

C CORPORATION

A “C” corporation pays taxes at the rate prescribed by Congress, and shares some of its profits with shareholders in the form of dividends. There has been much political ado recently about the high rate of corporate taxation, and how it may be hurting the American economy.[1] The best benefit of a corporation is that the liability of the shareholder is limited to the amount he or she must put in to pay for his or her shares. Once the shares are paid for, there is almost never individual liability for the debts or tor liability of the corporation.

S CORPORAITON

An S corporation shares the benefit of limited shareholder liability with a C corporation, but passes through its profits to the shareholders, like a partnership. Therefore one could say that an S Corporation is a hybrid of C corporation and a partnership. The shareholders of an S corporation pay tax on their respective shares of the profits on their individual Form 1040 return.

LIMITED LIABILITY COMPANY

A limited liability company (“LLC”) is a German import. The Federal Republic of Germany has had this form of business organization for many years. In Germany the acronym letters for LLC are GMBH (Don’t ask me to spell out the words in German.) An LLC has the same benefit of limited owner liability as a corporation. If you are a one-person LLC, when you apply to IRS for that all-important Employer ID Number, the IRS will tell you that your LLC is a “Disregarded Entity.” That is bureaucratic jargon for this: You are going back to Form 1040 Schedule C, and Schedule SE, unless you fill out and submit Form 2553 in the first month of your tax year, electing to report taxes as an S Corporation. An LLC with 2 or more members can also elect to be taxed as a partnership. My experience is that the S Election, as it is called, is the better approach. Please forgive the legalese words, but I was trying to explain the Internal Revenue Code, which is just about impossible to explain in plain English.

RECORD KEEPING, COSTS, FORMALITIES

In every instance, you must keep clear and discernible records. There a number of well-known and reliable software products to help you with this tasks. In Pennsylvania, the organizational costs (filing fee

with the state, legal advertising and the like) are a bit less for an LLC than for a corporation. However, do not let the tail wag the dog. Initial organizational expense is far less important than the long term well-being of you and your enterprise.

SHOULD YOU USE A LAWYER?

Of course I am going to tell you to use a lawyer, preferably me. There are robotic services that charge a bit less than an attorney. We charge a bit more than the robot. Why? Try asking the robot a follow-up question. One of the robotic companies tells you that you can consult with one of their attorneys. What attorney? What experience? Quoting the law from what state?

Organizing your business is a life-changing experience. You should not go it alone.

Buy local! Use our “Contact Us” utility on this website; or askdave@daviddunnlaw.com; or just give us a call. We can help. 610-439-1500.

[1] The Internal Revenue Code of 2017 purports to give tax relief to businesses. Whether this is a giveaway to the big guys, leaving “Crumbs” for the rest of us, or whether this could be the fuel additive that powers up the economy for sustained growth is an ongoing – and probably endless-- topic  for political debate.

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