Should I Incorporate My Online 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, let's 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:
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.
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
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.
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.
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.
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.
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.
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.
© 1999- Harry McGrath, Inc., DBA Skip McGrath, Auction Seller's Resource and Vision-One Marketing. All Rights Reserved.
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