Should I incorporate?

If you’re performing services making more than about $30-40,000 per year, you should consider incorporating as an “S” Corporation.

If you own rental real estate and want an added layer of liability protection, you should probably form an LLC.

Think of incorporation as a “next step” once you’ve started to succeed in your business. There are tax benefits at higher income levels that can be negative effects at lower income levels.

It may seem complicated, but imagine paying a monthly flat fee of $100 for phone service—is it a “good deal?” It depends on your phone usage!  An “S” Corporation is similar, with a few added nuances.

As a sole-proprietor, all your business income is included on your personal tax return.  You are responsible to pay Self-Employment tax on all your Earned Income, on top of the regular income tax. 

Self-Employment tax is approximately 15% on the first $100,000 of income, and roughly 3% additional on amounts above $100,000.  For sole-proprietors and partners, this is reported on the Schedule SE.

As an employee this money is withheld from your paycheck, a tax matched and paid by your employer.

Partnerships are taxed in the same way as sole-proprietors—you are just combining your business with another person.  You still pay Self-Employment tax on the Earned Income.

The Limited Partnership may allow you to avoid self-employment tax if you are “only an investor” – but if you are performing services, you’ll pay the tax.

The LLC or Limited Liability Company is a type of partnership, and can offer some liability protection for the owners.  The LLC is no substitute for proper insurance coverage. 

In California, you may have a Single Member LLC which is an LLC owned by only one person.  The IRS says a single person can not be a “partnership,” and disregards the LLC structure for tax purposes: the Single Member LLC files a Schedule C, as if it were a sole-proprietorship.

The Single Member LLC must still file its own California return each year.

The reason we often suggest the LLC for property owners is rental income is not Earned Income and is not subject to Self-Employment tax.

The tax advantage of the “S” Corporation is in possibly avoiding SOME of the Self-Employment tax on Earned Income that would otherwise be taxed for a sole-proprietor.

In the “S” Corporation, money is paid to employees as wage, including the owner.  A “dividend-like” payment may also be made to the owner that is not subject to Self-Employment tax.  When you receive a dividend from Ford Motor Company, for example, it is not Earned Income, it is a payment for the use of your capital.

Because of the potential tax savings, there are restrictions on who can become an “S” Corporation, and requirements to stay legal.  For example, you must be a US citizen or resident to own an “S” Corporation and the corporation must pay a “reasonable wage” to the owner.

For more information about entities, e-mail Andy@TaxBuddha.com and visit their website www.TaxBuddha.com.