A question we often encounter is “Should I incorporate?” The short answer is “Absolutely”.
As usual, I am not an attorney or financial advisor, so nothing you read on this site should be construed as legal or professional financial advice. That said, in my experience incorporation provides many benefits to a small business, compared to operating as a proprietorship or as an LLC. The only real cost is that of an extra tax return each year and some annual shareholder meetings and so on. The benefits to incorporating include:
• Clear division between business and personal income, expenses and deductions.
• Well-defined ownership interests and responsibilities.
• A more professional cachet.
• Greater access to more and better business-to-business opportunities.
When we speak of incorporating, we are talking about creating what is known in IRS parlance as a “C” corporation, rather than the nominally simpler but less impressive “S” corporation. We’ll go into the details of how to incorporate in a future article. Including the C corp, then, the main types of alternate business structures, in increasing order of complexity, and perceived value in the eyes of potential clients, are:
• Sole Proprietorship
• Limited Liability Company (LLC)
• S Corporation
• C Corporation
Let’s look at each of these in turn.
This is you, your “business entity” as an employee, typically as a W-2 employee, and you pay your taxes with a Form 1040. Other than perhaps some investments (hopefully), itemized deductions, and child tax credits if on the lower end of the income spectrum (or Alternative Minimum Tax if not), your taxes are probably relatively simple. Your bookkeeping is thus simple, and, in return, your economic opportunities are pretty much limited to whatever job you have or can find.
One step up the sophistication ladder is a sole proprietorship. You still do business as you. But now, you file additional forms with your 1040, including Schedule C (for business income and loss), D (for capital gains or losses), E (for real estate gains or losses), F (for farm income or loss), and/or Form 4562 (for depreciation or amortization), or some combination of the above. All of this links back into your Form 1040, which has begun to fill up quite a bit.
From the outside world, there is no difference between you as an individual and you as a sole proprietor. If you aren’t making money as a W-2 employee, then you will be paid on a 1099 basis. A future article will go into what 1099 means, but suffice it for now that companies, your future client base, avoid paying individuals as 1099s. The main reason for this is that if you fail to pay your taxes on those payments, the payor has to pay them as a penalty. As a result, companies may grudgingly engage with sole proprietors, but will often expect to withhold a portion of your earnings as if you are W-2. Many of them won’t even make the effort and find some other way to fill their needs.
You will get more opportunities as a sole proprietor just by saying those words (and being able to clearly discuss the 1099 risks to your potential clients) than you will as an individual, but not by much. You will get to deduct expenses on what you earn as a business to a greater degree than you will as an individual employee, but your record-keeping and justifications for those expenses must be meticulous. The IRS is rumored to take a dim view (often legitimately) of aggressive expense deductions when it comes to sole proprietors, however, so be wary. Avoid the temptation to call everything a business expense unless you can back it up in a rational way.
Limited Liability Company (LLC)
The next step up the business structure ladder is the LLC. This is one of the most popular business structures. It is necessary to file some paperwork with the state (usually the Secretary of State’s office) to form an LLC, and then you have to file additional reports and fees each year thereafter to maintain the LLC. Unlike a sole proprietorship, more than one person can be part of an LLC. Your taxes become slightly more complicated, but not by much. All those additional forms needed by the sole proprietor now get filled out in the name of the LLC, and the responsibilities of those filings shared by the individuals involved, and reported with their individual returns.
From a client’s point of view, LLCs will get paid by clients also on a 1099 basis, but the non-payment risk to the client is reduced. The LLC is a separate legal entity, just as if it were a separate person, although this person is intimately linked to the individuals, called partners here, who created the LLC.
One major drawback of the LLC is that the definition of responsibilities, including financial responsibility, and who gets how much of the proceeds of each business transaction, is determined by agreements among the partners. This means that it is difficult and unwieldy to take on new partners, as it is difficult to determine what other side agreements might be floating around, or whether one of the partners has blown the operating budget on a boat. For this reason, sophisticated potential investors will be leery of getting involved with an existing LLC. However, these same people will often demand that you get involved with theirs, or a new one they intend to create on your behalf. You should exhibit similar leeriness in considering this option.
An LLC may be the perfect option for a single person who isn’t going into business with anyone else, though. As soon as a second person is involved, such as a husband and wife or other family team, a corporation provides more benefits. Many lawyers will choose an LLC (or equivalent LLP in some jurisdictions). The side agreements work for them, because, after all, they are lawyers, and that kind of entangling partnership is their thing.
An S corporation is a full-fledged corporation, with a reduced status only due to a special IRS classification. Like an LLC, either type of corporation is a separate legal entity, registered with the Secretary of State’s office, and requires annual renewals. Either type of corporation also has shareholders who are issued shares of stock, and must hold periodic shareholder meetings to elect officers and perform other business. The IRS distinction between an S and a C corporation is that the shareholders of an S corporation file the corporation’s tax returns with their personal tax returns, just as an LLC does.
From a business perspective, S corporations have the reputation of being wannabes, separate entities in name only. Often, an S corporation will have less cachet with potential clients than an LLC, despite their increased operating complexity. One common use for S corporations is to facilitate business-to-business transactions rather than as a sole proprietor, often for individual contractors. However, the perception of reduced status will often limit your ability to close those deals in the first place; in these circumstances payment never has a chance to become an issue.
Since all the record-keeping of a full-fledged C corporation, and volume of tax forms, is the same in both cases, don’t damage your reputation with an S corporation. The only real difference is a declaratory form you file with the IRS to say you want an S corp. Don’t do it.
A C corporation is the real deal, and has the most powerful cachet of all the business entities at your disposal. Yes, more tax forms are required, filing a separate Form 1120 and attachments instead of the personal Form 1040 (which you, as an individual, still file). However, all the supporting attachment forms, such as Schedule D, Form 4562 and so on, were already required at the sole proprietor level and beyond. Although the forms themselves are different in some cases, the information on those forms was already required. Shareholder issues and annual meetings were also already required at the S corporation level. If your business is being properly run, you need to have a handle on all of this information anyway, so go ahead and take the full plunge. C corps also have more leeway with expense deductions, although some items which are clearly personal in nature remain a big no-no.
A C corporation also allows you to attract potential investors and partners without needing to expose personal tax returns, as would be required with an LLC or S corp. If investing in a C corporation yourself, you will want to have a shareholder’s agreement with anti-dilution clauses and so on. This sort of thing is bubblegum for a good business attorney, and greatly simplified over the rat’s-nest nightmare that an LLC might present. In most states, you will need at least two people in order to form a corporation, which is perfect for a husband and wife or other family team.
One good advantage with a corporation (S or C) is that stealing from the corporation is a lot harder to hide, and penalties are stiffer. While embezzlement with an LLC will often be seen as a partner spat, appropriate for a civil case and that’s about it, the same behavior conducted with a corporation can more easily trigger criminal charges. Corporations, especially C corporations, if well-run, do a much better job of keeping unrelated parties honest.
For our purposes here, though, the main advantage of a C corporation is the perception that you are in it for real. Businesses, of any form, prefer doing business with C corporations, as these present the least risk of tax penalties when making payments. We’ll talk more about these details in future articles.
If you are just getting your toes wet, run your business as a sole proprietor until you are ready to take the plunge and incorporate. As a sole proprietor, you will be filling out much of the same tax return paperwork as a C corp does, and keeping the same records, so make the leap as soon as practical. If you are a confirmed lone wolf, and expect to stay that way forever, then an LLC might be the right approach. If I were a lone wolf, I would still look around for a friend as a 1% shareholder or whatever and try to get incorporated anyway. In any case, stay away from the S corp; the reduction in status isn’t worth the imaginary simplification.
Bottom line, if you are going into business for real, shoot for the C corp from day one.