When Is Your Business Too Small to Incorporate?
Too few people ask the question, "when is a business too small for incorporation"? However, the right answer to this question can greatly simplify your business affairs. Accordingly, you want to ask and carefully answer the "too small" question.
Note: Most of what I say below also applies to limited liability companies as well, but read the last paragraph about LLCs treated as disregarded entities.
Quick Review of Incorporation Benefits
Let me start by pointing out that small business incorporation delivers a couple of benefits.
The first benefit is this: Incorporation limits the financial liability of the business's owners. Or, more precisely, the owners of the business are not automatically liable for the debts and obligations of the business merely because they're owners.
A second benefit concerns taxes: As a general rule, a corporation can save its owners payroll taxes (through the S corporation tax accounting rules), and may sometimes save its owners income taxes.
Roughly speaking, then, those two benefits are what you get by incorporating your small business.
Accounting for the Costs of Small Business Incorporation
As the saying goes, unfortunately, there's no such thing as a free lunch. And so you won't be surprised to hear that incorporation adds costs to your small business's operation. Specifically, incorporation tends to increase your accounting costs, both in terms of day-to-day bookkeeping and year-end tax preparation stuff. And incorporation automatically increases the fees and taxes you pay your state because the state, after all, expects your business to pay for the limitation of liability you receive by incorporating.
As far as accounting and bookkeeping costs, these probably run, at a minimum, from a few hundred dollars a year (if you're operating someplace that's got a low cost of living, maybe a rural area in the west) to well over a thousand dollars a year (if you're in a high-cost big city on either coast).
State fees and taxes, of course, vary from state to state. If you're operating someplace that's small-business-friendly (probably, very honestly, a "red" state in the south or west), you may only pay a few hundred dollars a year (sometimes less) for a small business corporation. If you're operating someplace that's not small-business-friendly (California, New York, and many of the "blue" states in the northeast), you'll often pay close to $1,000 a year at a minimum for small business incorporation.
California, for example, levies at least an $800 minimum franchise fee on small LLC and S corporations--even those only generating a few thousand dollars of revenue and losing money.
Trading Certain Costs for Possible Liability Protection and Tax Savings
So, the tradeoff, then, is gaining the possible benefits of liability protection and tax savings at the cost of extra accounting fees and state taxes. You want to make sure that you get benefits in line with the costs you may incur. With that in mind, let me share some rules of thumb:
1. If you're in a service business and the only worker or you're required to provide personal guarantees on loans or contracts with vendors or customers, you're not getting much of any liability protection. So you certainly don't, in this situation, want to incorporate for the "liability protection" reason. Just to make this point clear, any personal guarantee that you provide will "negate" the liability protection of the corporation or LLC. Furthermore, while a corporation or LLC will protect you from liability exposure based on your ownership, if you're working in the business, your status as a worker may (if you're personally negligent) create liability. Example: Incorporating a trucking business won't protect you from personal liability if you're driving a truck that runs somebody over.
2. Tax benefits from incorporation don't really become significant until you're making at least a goodly portion more than what would be reasonable salary for someone doing your job. In other words, if the job you do for your small business corporation is worth, say, $30,000 a year, there's no benefit to incorporating the business until your personal annual profits are well in excess of $30,000. At levels of profitability less than $30,000 a year, you won't be saving any money with the corporation--though you will be paying all the accounting costs. And even at, say, $40,000 a year, while you might save a little bit in taxes (perhaps at most $1,500 annually), you won't really benefiting because your accountant's invoices and the state fees will eat up all of these savings.
3. One-, two- and three-employee professional service corporations, starting in 2011, will find it much more difficult to benefit from S corporation status. In a nutshell, professional service corporations with three or fewer key employees will be disqualified from using S corporation status to save self-employment taxes. (Read more about this in the "What is a disqualified S corporation?" FAQ question.)
A Few Words About Limited Liability Companies
One final thought in closing: If you're a one-owner business, you do have an alternative to incorporation that, though it doesn't save you from paying the state its fees, often will minimize your accounting costs; you can form a limited liability company and let the LLC's income and deductions get reported on your personal return. By default, tax laws treat an LLC with one owner as a sole proprietorship if the LLC operates an active trade or business. In this case, the LLC owner enjoys all the simplicity of a sole proprietor's accounting and tax return preparation and at the same gains good liability protection.
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