Should I Incorporate My eBay Business?

by: Skip McGrath

I am often asked this question and the basic answer is: “If you are trying to build a serious eBay business then the answer is yes.” To help you understand why, lets take a look at the various type of business structure and their benefits.

There are three types of business structures available to the small business owner in The United States and Canada today:

	Sole Proprietorship
	Corporation
	Partnership

Partnerships are not really appropriate for an online business. These are used mostly by lawyers and accountants to share costs and profits among professionals, so we won’ t really discuss them here.

Sole Proprietorship

A sole proprietor is the most basic form of business structure and is, in fact, the default business structure in the United States. If you do not incorporate or form a partnership, the IRS will treat you as a sole proprietor.

If you are in business with your spouse, you are still a sole proprietorship even though both of you are in the business. If, however, you form an “informal” partnership with someone, the IRS will treat your both as sole proprietors. For example, I once owned a racing glider in partnership with a friend. We didn’t form a formal partnership, but we split the cost and the expenses of the purchasing and owning the glider. We kept the glider in Minden, Nevada which has some of the best thermal soaring conditions in the world. Glider pilots came from all over the world to fly there. We rented the glider out on a daily basis and split the income. Because we were an “informal” partnership, each year we would file our own taxes with the IRS as individual sole proprietors each showing our half of the income and expenses.

My wife and I ran our antique business and even our first year in our eBay business as sole proprietors. This category allows you almost all of the business expenses and deductions that a corporation can get.

Each year when you do your personal taxes, you file an extra form with your taxes called a Schedule C. Schedule C is where you list your business income and expenses. If you make a profit, this money is added to any other money you made from salary or any other income and in taxed at the normal personal rate. If you make a loss, you can deduct the loss from your other income.

Corporations

There are several types of corporations. The most common are called an “S” type and a “C” type by the IRS. The S-type Corporation is the most common corporation used by most small businesses in the US today. The difference in the two types of corporations is very important to you. An S-type Corporation does not pay any taxes on its profits. Instead all the profit or loss flows through the corporation to the stockholders (that’s you) and is only taxed once.

The S-type corporation is not really a separate “type” of corporation, it is really a general corporation that elects to file their taxes a certain way. Here is how the IRS describes an S-Corp:

An S Corporation begins its existence as a general, for-profit corporation upon the filing of Articles of Incorporation. Once formed, a general for-profit corporation that has not requested "S Corporation Status" with the IRS will be required to pay income tax on taxable income generated by the corporation. In addition, any dividends distributed to shareholders may be subject to taxation as dividend income to that shareholder as well (hence .the problem of "double taxation" that can occur in a 'Non-S Corporation').

After the corporation has been formed, it may elect "S Corporation Status" by submitting IRS form 2553 to the Internal Revenue Service. Once this filing is complete, the corporation is taxed similar to a sole proprietorship or partnership rather than as a separate entity. The income is now "passed-through" to the shareholders for purposes of computing tax liability. Therefore, each shareholder's individual tax return will report the income or loss generated by the S corporation.

There are significant advantages to incorporating. The primary advantage is limiting your liability. A corporation is considered a “person” under the law for purposes of contracting and liability. Once you incorporate, it is the corporation that will purchase inventory that you will resell and the corporation that will sell the goods on eBay or your web store.

This liability protection is extremely important to the small business owner. For example: You sell one of those new electric scooters on eBay to someone who gives it to their child for Christmas. On Christmas day the child is running it in the street in front of his or her home. A wheel falls off and the child crashes injuring him or herself. It would be difficult for the parents to sue the company in China who made the scooter. They could, and probably would, sue the importer or distributor you purchased it from, but they would also sue you. Because it is virtually impossible for you to purchase product liability insurance you are now exposed to this liability. In this case, because you are incorporated, the lawyers would be suing the corporation –not you personally. If they won, they could only attach the corporation’s assets, not your personal assets such as your home and retirement funds. For this reason, most small business owners keep a minimum of assets in their corporation and a minimum of funds in their corporate bank accounts.

This is a simplified explanation of how incorporating protects you against personal liability. There are rules you must follow in how you set up and run your corporation to prevent a potential plaintiff from reaching through the corporation to attach your personal assets. If you don’t maintain proper paperwork and files, commingle money from the corporation or using the corporate debit card for personal expenses you can open yourself to personal liability. This is called “piercing the corporate veil.” Lawyers and creditors always try this when they file a lawsuit against a small-business corporation. As long as you follow the rules, they are rarely successful doing this.

Once you incorporate there are some simple rules to follow. Mostly they relate to record keeping and documenting major decisions such as making a major purchase (car, computer, etc.), opening a bank account and so on. The paperwork is not that difficult or time-consuming. I have been personally incorporated for the past five years and the extra paperwork amounts to about 1 hour a month. That is a small price to pay for the tax savings and liability protection I enjoy.

Another advantage of incorporating is credibility. When you have a business name that ends with “Inc.” other businesses take you more seriously. Wholesaler distributors will be more willing to deal with you. It will be easier to gain entry to wholesale merchandise marts and trade shows and it will be easier to find trade credit.

After liability protection, the greatest advantage of incorporating is the potential tax savings. One of the most significant tax advantages is the ability to reduce your self-employment taxes (social security and Medicare taxes). When you work for a company your employer takes 7.65% out of your paycheck on your first $90,000 of income to pay for your contribution to social security and Medicare. The employer then matches this amount before sending it to the government so the total is over 15%.

When you are self-employed as a sole proprietor, you are both the employer and the employee so you have to pay this 15% plus your regular income taxes on the whole amount of your earnings.

When you incorporate, the corporation can “hire” you as an employee and pay you a salary. Now the IRS requires this salary be reasonable, but it can me much lower than the $90,000 maximum SSI taxable amount. For example, if you made a $50,000 profit in the corporation, you could pay yourself and/or your spouse a salary of $25,000 and take the rest of the money as dividends. This way you only pay the 15% self-employment tax on $25,000 salary instead of the full $50,000. This results in a tax savings of about $3,750 per year. You will still have to pay the normal personal income tax on the combined income of your salary and dividends but you will always save this basic amount.

One disadvantage of this method is your contribution to social security is lower. A lower contribution will result in you receiving lower social security benefits when you retire. However, this can be greatly offset if you place the $3,750 you save into a tax-advantaged retirement account. As social security returns on average a 1% return over time, if you earn even a small return of 4% or 5% a year on the retirement account, you will have more money to retire on than if you relied only on social security. Furthermore, when you place the $3,750 into a tax-advantaged retirement account, you don’t pay taxes on the invested amount and the investment accumulates tax-free until your reach retirement age.

There are several other tax advantages of incorporating. A common one is the office-in-the-home. If you keep an office at home, even if you have another commercial office, instead of deducting the percentage of space and costs as a sole proprietor would do, you simply rent your office to the corporation. You can charge the corporation the same amount that equal space would cost if you rented space in town. Then on your personal taxes, you can deduct the cost of the office space as a business expense and take depreciation on that part of your home.

Car expense is usually a large expense for self-employed business owners. Instead of deducting business mileage on your car, the corporation can buy a car (or your car) and pay all the expenses such as insurance, gas, oil, maintenance, tires and so on. This is much simpler than allocating a percentage of business use and keeping detailed mileage logs.

A corporation has more flexibility in setting up tax advantaged retirement programs that allow you to invest your profits on a pre-tax basis. The amounts you are allowed to invest pre-tax are larger than an individual would be allowed in a simple IRA. This is a great way to shelter your profits from taxes and set money aside for your retirement.

Another advantage of incorporating is that you can hire your children as employees. Instead of giving your children an allowance, hire them to help you with small tasks such as cleaning up the office, washing to company car, helping with packing and shipping and so on. This way the money you would probably give your children anyway becomes an expense for the corporation and reduces your taxable income.

It is very simple and inexpensive to set up a corporation online. After you set up your corporation, you should next hire a CPA who will explain the costs your corporation can expense, the deductions you can take and the paperwork required. Your CPA can also help you with quarterly tax returns and filing any state sales tax returns as well as preparing your federal corporate and personal tax returns at the end of the year. Depending on the level of work a CPA does for you this should cost between $300 and $1,000 a year for these services. When you consider how much you will save in taxes this professional help is well worth the investment.

The final advantage of an S-Corp. is the fact that you are less likely to be audited. The IRS has a separate compliance and audit division for corporations. The IRS Corporate Audit Division has finite resources and can only do so many audits per year. Therefore they tend to go after the larger corporations where they can find larger amounts of money. This doesn’t mean you are audit proof –it just means that statistically you have less chance of being audited than a sole proprietor or a partnership. Once again, your CPA can advise you if you are doing anything that would raise the “audit flag” with the IRS and you can take the proper action to avoid this.

Always follow your CPA’s advice. I have only been through one audit, but it was pure hell. Amazingly my CPA was with me every step of the way, and in the end I actually ended up getting over $300 back. The IRS only disallowed one deduction for $45, but we uncovered over $1,200 in expenses I had not claimed while researching through all of our files and receipts. Nevertheless, I would have gladly let the IRS keep the $300 if I could have avoided the audit.

You can set up a corporation very simply online. One of the largest companies is Legal Zoom Incorporations & LLC's.  Depending on the state you reside in, or incorporate in, the fees to incorporate will usually be between $100 and $300.

You do not have to incorporate in your own state if their fees are too high. A lot of companies incorporate in Nevada or Delaware because they have lower fees and attractive incorporation laws.  However you must register as a foreign corporation in your home state. This may subject you to additional fees and or taxes depending on your state.

Limited Liability Corporation

There is one additional type of structure. It is called a Limited Liability Corporation (LLC). This is sort of a hybrid between a partnership and a corporation. It allows you set up your own company or to form a partnership with someone, yet enjoy the limited liability of a corporation. If you want to go into partnership with someone else you might want to explore this avenue. Personally I would always recommend the simple incorporation route and take the S-Chapter election and become an S-Corp. This is simpler in the long run. Partnerships can be very messy to dissolve when the partners disagree over business issues or experience personality conflicts.

With Legal Zoom, mentioned above, you can set up either a S-type Corporation or and LLC.