A large part of Linda de Marlor’s accounting business involves counseling people on whether or not to incorporate their practice. Yet, when she started Tax-Masters, a Rockville, Md.-based accounting firm in 1980, the choice to her was clear: stay a sole proprietor.
Her decision to not incorporate came down to money. She didn’t have enough cash to pay a lawyer to help her become a corporation—but that changed two years later. “As soon as I had a couple of years under my belt, I was able to afford a lawyer,” she said. “Then I incorporated.”
There are many reasons lawyers, doctors, accountants and other professionals should incorporate, but de Marlor set up her corporation to protect her name. In some states, simply incorporating means that no one else can use a company’s moniker, she said.
Others want to incorporate to protect themselves from any legal liability, as a way to save more for retirement or to have the ability to write off medical bills. Some business owners may want to stay a sole proprietor as long as they can.
Here’s how you can decide what to do.
Look at legal
The main reason to incorporate is for asset protection, said Paul DeLauro, a Beverly Hills-based senior vice president and manager of wealth planning for City National Bank. If an incorporated business owner faces litigation, then in most cases their personal wealth is protected.
“The entire genesis of corporate law was to allow people to go into business without the fear that the failure of the business would lead to the collapse of one’s personal finances,” he said. “You want to limit the liability to your practice or risk everything that you own.”
But just because an entrepreneur incorporates doesn’t mean his or her personal assets are always protected. It is possible to “pierce the corporate veil” if the owner uses business capital or assets for personal purposes, said DeLauro.
For instance, if a professional pays for personal vacations on a corporate credit card, or a non-work car is being paid for by the company, then the business owner may not be protected. Corporate expenses must be kept separate from personal ones, DeLauro said.
If they aren’t, “it can then be argued that the doctor or lawyer never honored the corporate form,” he said. “So never co-mingle funds.”
U.S. corporate tax rates are some of the highest in the developed world, so some people prefer to stay as a sole proprietor in order to pay a single personal tax. However, that works only if you don’t need the legal protection that a corporation can provide.
If you decide to incorporate, you have a variety of options, which include C corporations, S corporations and LLCs. The latter two are considered pass-through entities, meaning the income from the business is taxed at the personal level and does not incur a corporate income tax
If there are employees, then the 15.3 percent “self-employment tax”—Social Security and Medicare taxes—will have to be paid on the employees’ salary, but anything declared as profits will not be subject to corporate taxes, said de Marlor. Rather, the profits are declared on the owners’ personal income, which means the business owner must pay only the personal tax rate on those funds.
C corporations are subject to double taxation. That means they will be hit with a corporate tax bill and then the business owner will also have to pay personal income tax on the money he or she withdraws. However, C corps allow owners to deduct medical expenses. There’s also no limit on the number of shareholders in a C corp, while an S corp is limited to 100 shareholders.
For some people, the choice between sole proprietorship or incorporation comes down to how they want to invest their pre-tax income, said Mike Geri, a Seattle-based financial advisor with RBC Wealth Management.
The former can invest only in personal retirement savings accounts, like an IRA, while a corporation is allowed to set up a 401(k). This can be significant depending on how much one wants to save.
“You can have much higher contributions to your retirement plans in a corporation,” Geri said.
DeLauro pointed out that people age 50 and older are allowed to contribute $6,500 to an IRA, compared to $24,000 in a 401(k). Other types of corporate savings accounts allow a business owner to contribute even more.
“If you want to save more pre-tax income using qualified retirement plans, then incorporating can help you do that,” DeLauro said.
Consider partners and costs
Geri said incorporation may also be a good idea if you have a business partner. If that partner does something dishonest and gets sued, you can argue that you had nothing to do with the problem to avoid personal liability. If you’re not incorporated, then the person suing may be able to go after both partners’ personal assets.
Keep in mind that it is more expensive to be incorporated, because more paperwork needs to be filed. A business owner will have to pay about $500 to set it up and about $2,000 in annual fees for accounting work, said de Marlor. That number can grow depending on the size of the company.
When it comes down to it, though, most professionals will want to incorporate, said DeLauro, and they should do it as soon as they can.
“The day you go into business,” he said. “You want to make sure you’ve got the protections of the court at your back. I’ve met with a lot of professionals who did not incorporate and failed to realize that all of their personal property was now at risk. Why wait?”
De Marlor, who still runs an S corp but also set up an LLC as a parent company, concurs.
“I would never advise anyone to run any business that wasn’t asset-protected,” she said. “The best thing you can do is have this brick wall.”
This article was originally published on Forbes WealthVoice.