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Incorporating Your Business: Sole Proprietorship, LLC, or Corporation

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When I started blogging, my “business” was a sole proprietorship. As I began to earn a little more income, I decided to move from a sole proprietorship to a limited liability corporation, an LLC, to reduce my personal liability. As the years passed and business grew, I ultimately converted to a S Corporation for tax purposes. At each step of the way, I analyzed whether going from one business entity to another made sense from a financial and a legal standpoint. You have to weigh all these factors before you decide whether filing the paperwork is worth it.

Sole Proprietorship

A sole proprietorship is basically a throwaway business entity because you are the business. You and your business are one and the same. You don’t need to file any paperwork to be a sole proprietorship, you simply recognize your business income on your tax return (1040 Schedule C) and the income is treated as self-employment income. This is the easiest of all the business entities because almost always don’t have to do anything! You have to confirm this with your local government, as some require you to register a sole proprietorship, but in most cases you won’t have to do anything. If you don’t do a lot of business, sole proprietorship is probably, but not always, the best option for you.
Advantages: You usually don’t have to file any paperwork and the income is treated as your own income.
Disadvantages: Since you are the business, any liabilities your business has will be your personal liabilities. If your business is sued, the plaintiff can come after your personal assets to cover business debts. This is the biggest risk of sole proprietorships.

Limited Liability Corporation

A limited liability corporation is a business entity that protects you from business liabilities, like debts or lawsuits. It’s known as a “pass through tax entity” because the profit and loss are passed directly to the owners, who recognize them on 1040 Schedule C forms. There are exceptions to the liability such as if you personally hurt someone or you fail to withhold taxes for employees. You must take great care in keeping LLC and personal business separate, so this means you need to get a federal tax ID number, a business bank account, and keep things separated at all times. Forming an LLC requires you to file “Articles of Organization” or a “Certificate of Organization” with the local state government. In Maryland, you file Articles of Organization and pay a $100 fee.
Advantages: Offers protection against business debts and lawsuits as long as you keep things separate.
Disadvantages: Costs some money, different states charge different amounts for filing LLC registration papers. In Maryland, the $100 isn’t the end of the story, each year the state requires the business to file a personal property return, listing the personal property the business uses, which carries a $300 filing fee. LLCs are more expensive to maintain than Sole Proprietorships so be sure to check everything.

S Corporation

S Corporations offer the same liability protection as LLCs and additional tax benefits as well. The major tax difference between an S Corporation and a LLC is that the money paid out to shareholders is not subject to self-employment taxes. I am personally on the payroll for my business and paid a “reasonable salary,” with the balance of the profits paid out as dividends to me as the sole shareholder. The amount paid out as dividends is not subject to the employer’s half of Social Security and Medicare.

What is a “reasonable salary?” A “reasonable salary” is often defined as the amount you would pay someone to do your job in your company. As you know, Social Security withholdings are subject to a cap, you contribute 6.2% of your salary up to $106,800, any amount you earn above that is not subject to Social Security. Many places argue that the safest amount for “reasonable” is at the Social Security income cap, $106,800. If they want to argue that you should pay yourself more, the only benefit above that would be in the Medicare portion of FICA. However, you can set your reasonable salary at whatever you think is reasonable and people have successfully argued salaries of under $106,800 (let’s be honest, that’s really really high).

Advantages: All the liability protection that comes with LLCs plus a small tax benefit from not having to pay for FICA on income above what is paid out to me as salary.
Disadvantages: There is a lot more paperwork and expenses (incorporation agreements, bylaws, meetings, meeting minutes, payroll, etc.) and a lot more filings. You also lose access to a Self-Employment (SEP) IRA because you no longer have self-employment income. Your business earnings are “transferred” to you personally through a salary (W-2) or through dividends (1065 Schedule K-1), so you have no SChedule C income.

Should I Use a Filing Company?

Should you use a company like service to help prepare some of your documents? That depends. In Maryland, all it takes to incorporate an LLC is a one page form and a check. I certainly wouldn’t pay LegalZoom $149 for that (MyCorporation is running a promo where you can get free incorporation filings using code MYFREE). Check your state and municipality’s requirements when it comes to incorporating the type you want. If it’s really complicated, maybe you go with a service; if it’s really easy, do it yourself.

With the corporation, I had a business accountant at that point and they were familiar with all the necessary filings and requirements for S Corporations so I had them do it. If you’re going to go the S Corporation route, chances are you have the income to support a professional’s expertise and familiarity and have them do it for you. It’s better to pay a little to get it done right the first time than spend hours you probably need to devote to your business.

(Photo: barenboime)

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27 Responses to “Incorporating Your Business: Sole Proprietorship, LLC, or Corporation”

  1. Patrick says:

    I can definitely see the benefits of filing for an S Corp once your business reaches a certain size. Right now an LLC is probably the best for my operation, but I think that as it grows, I may consider an S Corp as well – self-employment taxes can make a big difference. Then receiving the rest as dividends is another benefit because they are taxed at a lower rate… Good stuff. :)

    • Jim says:

      One thing to really look into is the other expenses you may have related to an S Corp, because those can really add up.

      Those “dividends” aren’t taxed at the dividend tax rate, they’re taxed as income. :(

  2. Cap says:

    Think you meant FICA there when you said not having to pay for FICO on income above what is paid out to me as salary

    ;)

  3. Anonymous says:

    Is minimum wage “reasonable”?

  4. You laid it out really well but it still all seems so daunting. I don’t think I am in a place to worry about it right now, but if I need to in the future it seems like an awful lot to keep track of.

  5. A.J. says:

    What about deducting health insurance? Can you do that with any of these?

    • Aliefdfuffey says:

      There is an election to have health insurance come out of gross wages instead of net wages. Their is an election that you have to file with the IRS. Ask a CPA and a health care provider about this.

  6. James says:

    Very good information and advice. It’s very important to take care of this early on in the life of the business. If you wait you can get in some serious tax trouble.

  7. William says:

    re: an LLC as a pass through entity – “because the profit and loss are passed directly to the owners, who recognize them on 1040 Schedule C forms.”

    Not necessarily – you can elect for your LLC to be be ignored (sole member) for tax purposes, to be treated as a partnership, or even to be taxed as a corporation (by using Form 8832).

    So it’s best to think of an LLC as a legal entity versus a tax structure.

  8. thomas says:

    Sole P’s are a pretty bad idea simply for the reason you mention that you could lose everything in a lawsuit. The couple hundred for a LLC will be well worth it.

  9. tom says:

    so when is it a good idea to incorporate your blog? Any specific income levels?

  10. If your business is an important source of revenue to you and if you have personal assets to protect, please do not use an accountant or piece of software to organize your business. The accountant can advise you on the tax implications but there are so many other issues that are way beyond their expertise. One mistake and your corporate shield melts down in a hurry. I have seen those mistakes because the legal profession is paid well to clean them up.

  11. David says:

    My question is the same as Tom’s. When does it make sense to incorporate? I get the impression that the answer is as soon as you have an inflow of cash, even if your net income is still negative.

    Also, to ask a dumb question – if you have two people in your operation, does that make an LLC even more attractive than a sole proprietorship?

    • Jim says:

      For me, I think it makes sense as soon as possible to reduce personal liability.

      I think you want an LLC with two people because you don’t want to be personally liable for what the other person does.

  12. My Journey says:

    Not mentioned here, is that it is relatively easy to lose S-Corp Status causing a HUGE headache for your advisors (tax, legal or financial). One simple example is having more than 25% in passive income (i.e. rental property).

    • Jim says:

      Excellent point, I didn’t mention it because I didn’t know! (but I don’t have any passive income either, so that’s probably why my accountant didn’t mention it either)

  13. JR Moreau says:

    Can you revert from a LLC to a Sole Proprietorship? I got a tax ID in December for my startup consultancy. I didn’t make any money so filing seemed simple, but it seems quite complicated for what I’m looking to do with my business at the moment. I’m wishing I filed as a SP in the first place.

  14. Aliefdfuffey says:

    an S Corporation is the best business vehicle for anyone that does not mind the filing forms and having a CPA. The best part about the S Corp is your salary is set up like any other business which reasonable is around 30K-60K a year depended on the field. The other income to the business can be paid in distributions which would not have FICA that on it saving 15.3% there. Then you can capitalize your fixed goods which most are available to a Section 179 election up to $108K direct reduction in basis. Plus depending on the nature of your business if you have a lot of advertising promotions which might include some meals and entertainment, these can be reduced at 100% instead of the 50% tax rule on meals and entertainment.

  15. mapgirl says:

    Jim,

    My family went through turning their sole proprietorship over to an S Corp a few years ago. As we drew up shares and whatnot, my parents asked if I wanted shares and ownership responsibilities. I said no because my sibling was not participating and I was worried it would start making things messy for my personal taxes by having ownership of a corporate entity out of state, etc. as well as potential estate planning issues later. (sibling feeling left out, etc.)

    I know one reason why my folks did this was because my father was a sole proprietor, but by transferring assets like this, my mother would be able to hang on to their business more easily as an owner of the S Corp, vs an inheritor of the sole proprietorship.

    Now I know you and your wife are still quite young, but was anything like this a concern of yours?

  16. Rich W says:

    The information on the SEP is incorrect. SEP means “Simplified Employee Pension”, not “Self Employed”, and yes, it is an option for an S-corporation owner. The owner makes contributions for all employees, and since the owner is also an employee, it’s allowed. Take the time to read the IRS publication on retirement plans.

  17. Randy says:

    My partner and myself operated a rental property as a partnership, but last year we incorporated an LLC in June. Should we the LLC taxes include all the year or should they be seperated?

    • paul says:

      I am a self employed medical professional and contract my work exclusively in AK. I am presently INC.in WA state, which was easy at the time I was living in WA, but have recently moved my residence to GA. What may be the best move as I go forward, in terms of LLC etc ?

  18. My wife and I have or are a small mom and pop sewing shop in northern Minnesota. I’m having a hard time wrapping my mind around S-Corp versus what we are… a small sole source proprietorship. Is there an income threshold for becoming an S-Corp. We just got killed this year with Social Security withholding.

    • Jim says:

      There’s no income threshold for becoming an S-Corp and I don’t think Social Security withholding will change with the corporation type, but check with an accountant in your state.

  19. Soccer9040 says:

    I have a small company I started in college as a sole proprietorship. Well we rolled it up to an LLC and it was great for a few years. Now that I am out of college I dont have as much time to devote to the business, but we still keep it running. Now its just a pain in the butt during tax time. Yes the LLC was worth it then, but its too much for the little business now.

    I should just shut down the LLC and start running as a sole proprietor again.


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