Why Incorporate?
April 23, 2010 9:25 AM   Subscribe

What are the benefits of incorporating?

I work in entertainment and a lot of people incorporate, as either S-corps or C-corps. I've had it explained to me, but I still don't really grasp why and how it saves them money. Can you explain this to someone dumb about taxes?
posted by malhouse to Work & Money (10 answers total) 16 users marked this as a favorite
The primary reason to incorporate is to set up a Separate Legal Person, so if someone sues the corporation, your personal assets are shielded.

Beyond that, for an S-Corp, the major tax savings is that you expense more things pre-tax, so you don't end up paying taxes on money you're spending to run your business, but the business profits flow straight through onto your personal taxes.

For a C-Corp, the corporation can actually hold assets across tax years, so the income doesn't flow straight across. But it's a lot more complicated to get the accounting right.
posted by DaveP at 9:38 AM on April 23, 2010

None of this is legal or accounting advice. Do not use this information to make legal or financial decisions. If you are considering incorporating, consult a competent attorney in your jurisdiction.

The first and foremost reason to incorporate is to provide limited liability. If you're a regular person operating an unincorporated business and something your business does opens the door to liability, then the plaintiff can go after not just your business assets but also your personal assets, right down to your home, car, etc.

With a corporation, the business and personal assets are separated and the liability of the shareholders is limited to what they put into the business. Of course, the business owner may still have to put up personal property as collateral on a business loan, but that's a side issue.

Now, on to the taxes. Let's say you're a regular person making money. You pay personal income tax on that money.

Now let's say a corporation makes money. It pays corporate income tax on that money and its employees pay personal income tax on their wages.

Now let's say that corporation makes enough money that it turns a profit, which it then distributes to shareholders. Those shareholders will pay personal income tax on that money. So the government took a cut when the corporation earned the money and it takes a cut when the shareholders received their share. That's called double taxation.

Now, what if the corporation is very small and closely held? For example, what if there's only one shareholder? For that shareholder, his or her potential profit sharing gets nicked twice, which is unappealing. In that case, an S-corporation (or an LLC with S-corporation taxation) can be advantageous. Rather than being taxed twice, the profits will only be taxed once, as personal income for the shareholders.

The reasons for choosing to incorporate as a C-corporation are a little more complex. I'm not sure why an individually-owned or otherwise small business would choose the C-corporation structure. It's most commonly used for larger or publicly owned companies.
posted by jedicus at 9:46 AM on April 23, 2010

For consultants, it actually helps the people who hire them. If a person just hires you to do something, they're obligated to pay employer-related taxes. (This is often referred to as a "nanny tax", for a case where it very commonly kicks in.) Whereas, if you have a "personal corporation", they can engage your business as a service provider, and it's no different for them than if they went to the counter of any large service business and ordered up a service off of the rate card.

However, you then become responsible for paying the tax instead, as a "self-employment tax". This is the point that you really want to have an experienced tax accountant in your corner, so that you get it right and the Government doesn't come after you for what you might have missed.

Hope this helps.

(BTW, I'm not an accountant.)
posted by Citrus at 10:17 AM on April 23, 2010

My S-corp was started to get access to health insurance.
posted by Obscure Reference at 10:20 AM on April 23, 2010

The primary reason to incorporate is to set up a Separate Legal Person

Agreed, but note this depends on how you incorporate. As a single-payer LLC, my accountant made it very clear incorporating provided me with only the thinnest of shields.
posted by yerfatma at 10:21 AM on April 23, 2010

Your question is about the tax advantages, but first we should clear up the liability issue. A corporation can provide some limits to personal liability, but you could do the same using an LLC taxed as a sole proprietorship, so liability alone is not a very good reason to incorporate.

Citrus alludes to another issue but doesn't quite get it right. Some people that hire you may require that you be incorporated, not because it saves them taxes but because it saves them a little paperwork. If they hire you as an independent contractor, they must provide you and the IRS with a 1099 so that you can pay your self-employment taxes. If you are incorporated, they don't have to send a 1099. Either way, incorporated or independent contractor, they do not pay employment taxes. You pay the employment taxes. It just saves them the trouble of doing 1099s, so they may require that you be incorporated, usually as an S-corp. Some people also think that it removes some of the ambiguity between contractor and employee.

Many people do an S-corp to save on employment taxes, primarily Medicare. There are two ways to get money out of an S-corp. You can take it as wages or you can take it as dividends. In both cases you pay ordinary income taxes, but if you take it as wages, you must pay self-employment taxes of 15.3% in addition to income taxes.

So why not just take all of your S-corp income as dividends? The IRS considers this tax evasion and requires you to take a reasonable salary as wages. Reasonable is an ambiguous term, but many accountants suggest that you take a wage at least up to the cap for social security taxes which is about $100,000. Above that level you can take the rest as dividends. Keep in mind that while there is a cap for social security income there is no cap for Medicare income. Medicare taxes are 2.9%.

As an example, let's say that you make $200,000 in your S-corp. You take $100,000 as wages and pay income tax and 15.3% self-employment taxes on that portion. If you took the second $100,000 as wages, you would pay income tax, no social security tax because you are above the cap, but you would pay $2900 in Medicare tax since there is no cap. If you take the second $100,000 as dividends, you don't have to pay the $2900 of Medicare.

So from this example you can see that you can save a little on taxes but you have to balance that with the much more complicated tax forms and accounting. With the S-corp you have to do payroll, and send payroll taxes to the IRS. You have to fill out a W-2. You have to keep more complicated books that might require an accountant. I wouldn't suggest using an S-corp unless your clients require it or your income is above $100,000. It most cases it just isn't worth the complications.
posted by JackFlash at 12:49 PM on April 23, 2010 [7 favorites]

If you are self-employed and have a lot of deductibles, (for example, paying 25% of income in commission to agents and lawyers, etc) incorporating reduces the amount of total deductibles left for you to take (such as writing off company trips, or laptops, or whatever,) due to alternative minimum tax limits. But as a S-Corp, those deductibles are now business expenses, which is a whole 'nother ball game.

Also if you are a small S-corp that plays by the rules, you are far, far less likely to get audited than if you were an individual making the same amount of money. My accountant said it's because you are suddenly a small fish in a much larger pool.

This could be wrong, I am not an accountant. But this is my understanding of a couple of the advantages.
posted by egeanin at 12:57 PM on April 23, 2010

But as a S-Corp, those deductibles are now business expenses, which is a whole 'nother ball game.

Nope, expenses are expenses. They are deducted from gross income whether you are incorporated or not, so that is not an advantage.
posted by JackFlash at 1:19 PM on April 23, 2010

There are ton of misconceptions about the benefits of forming a corporation or limited liabilty company for tax purposes and/or asset protection.

Regarding asset protection, most people are referring to a limitation of liability. Incorporating or forming an LLC, however, will not necessarily protect you from tort liability. See this great post for a more thorough explanation.

Occasionally, you might be able to limit contractual liability by conducting your business through a corporation or LLC, but most savvy business people will also require you to sign important contracts in your personal capacity. Once you sign a contract in your personal capacity, you are on the hook--regardless of whether or not you have a company or corporation.

The reason that "limited liability" often gets thrown around as a benefit of incorporation is because it provides protection whenever a company grows beyond a single person. In these situations (and assuming the company is adequately capitalized), the "separate legal person" will protect your personal assets if an employee does something (i.e., gets in a wreck) that harms someone else. In that case, the person who is harmed could sue the person who hurt them (i.e., your employee) and your company. They could not, however, successfully sue you personally. If you didn't have a separate company, then the person who was harmed could sue your employee and you, in your personal capacity. Also be aware that in cases where the company is not adequately capitalized or the required corporate formalities have not been maintained, it would still be possible for the person who was harmed to sue your company and to "pierce the corporate veil," which would allow them to seize your personal assets to satisfy any judgment.

Taxes, however, are a better reason for incorporating or forming an LLC. In short, you can limit the amount of self-employment taxes you pay by setting up a company to issue you both a W-2 and a K-1. This article provides some more detail about that.

IANYL and I am not an accountant. Once you have a basic grasp of the potential tax advantages of setting up your own company, rather than operating as a sole proprietorship, you should find an accountant to fill in the blanks of your understanding.
posted by ajr at 1:56 PM on April 23, 2010

You don't ask this, but I thought I'd mention one of the negatives of incorporating. In California, corporations pay a minimum tax of $1000 per year (waved the first year). So if you incorporate, even if you have no income, you will be doing taxes and writing a check (or rather, four for estimated taxes) for your corporation.
posted by zippy at 8:57 AM on April 24, 2010

« Older Not a coal mine but...   |   How do I go about finding a plateau within a set... Newer »
This thread is closed to new comments.