Incorporate Your Business: Forming a LLC vs. Scorp
Stephen L. Nelson is the author of the bestselling books:
8434 154th Avenue NE
Redmond WA 98052
Tel: 425-881-7350
Fax: 425-671-0585
steve at stephenlnelson dot com

Serving Redmond, Bellevue and the greater Seattle area

Incorporate Your Business: Forming a LLC vs. Scorp

If you’re a new business owner, you may wonder whether you should incorporate your business. Well-meaning friends and business colleagues may even have encouraged you to look into the question of "forming a LLC vs. Scorp.”

It often is a good idea to incorporate your business for two basic reasons. First, you usually obtain some liability protection. With a corporation or LLC, business creditors may only be able to get repayment from the corporation. For example, if the corporation borrows $50,000 for some business purpose and then can’t repay the loan, the creditor may only be able to money from the corporation. If the corporation doesn’t have any money, the creditor won’t get repaid. And that might be true even if the shareholders who own and operate the corporation have money.

This liability protection isn’t perfect, I should note. Many situations exist where a business creditor can look beyond the assets of the corporation and to the managers and owners of the business for repayment. But when you incorporate your business, you always get additional liability protection over business forms such as a sole proprietorship or a general partnership.

A second benefit accrues when you incorporate your business, too. The right corporate choice can produce big tax savings for businesses. Tax law views corporations either as C-corporations or S-corporations. C corporations can provide all their employees, including shareholder-employees, with generous tax deductible fringe benefit packages. S-corps allow shareholders to avoid double-taxation on profits and sometimes allow shareholder-employees to save on self-employment taxes.

You have undoubtedly heard of limited liability companies, also known as LLCs. You may therefore be wrestling with the "forming a LLC vs Scorp" question. An LLC is another way to get liability protection. And in many cases, LLCs represent a superior form of liability protection. An LLC doesn’t require as much red tape as a corporation. An LLC is also a chameleon for tax purposes—in other words, an LLC can be treated as just about anything for tax purposes. An LLC with one owner (called a member) can be treated as a sole proprietorship, a C-corporation, or an S-Corp. An LLC with two or more members can be treated as partnership, a C corporation, or an S-corp.

You can set up a corporation or LLC yourself. Or you can pay an attorney to do the work for you. The actual set up isn’t difficult. Setting up an LLC in Washington State requires a simple one page form you can download from the Washington State Secretary of State’s web page. But one huge advantage of paying an attorney, say, a $1,000 to set up your corporation or LLC is that the he or she can answer your questions about the liability protection you want to achieve.

Whether you set up a corporation or an LLC, you have choices to make about how the new entity should be treated for tax purposes. For example, if you set up a corporation, should the corporation be a C corporation or an S corporation? If you set up an LLC, should it be a partnership, a sole proprietorship, a C corporation, or an S corporation? You should not perform this analysis yourself. People who don’t understand the tax laws tend to make very expensive mistakes—mistakes which can be difficult and sometimes impossible to undo.

One other point needs to be made concerning the option of forming a corporation or LLC: The business pays extra costs by incorporating—costs beyond those required to set the thing up. In Washington State , for example, you can expect to pay an extra $60 to $300 annually in corporate or LLC annual license fees depending on the type of business. You may increase your personal property taxes by setting up a corporation or an LLC. You will pay more for your tax return if you end up with an entity that, for income tax purposes, is a partnership, C corporation or S corporation. Finally, you will need to put owners on the company payroll (even if the owners are the only employees!) and this will increase both your payroll accounting work and subject each owner to roughly $400 of federal unemployment tax.

Let me try to distill all of this down to a few rules of thumb:

  1. Rule 1: If you’re a sole proprietor making profits equal to what’s a fair salary for someone who does your job (or less) and you want liability protection, you should usually set up a single-member limited liability company. You’ll keep your accounting and taxes very simple because for tax purposes, you’ll still be a sole proprietor. Yet you’ll get a degree of liability protection.
  2. Rule 2: If you’re a sole proprietor making profits in excess of what’s a fair salary, you should probably set up an S corporation. Your accounting and taxes will become much more complicated, but you’ll probably save thousands of dollars in self-employment taxes. One complication here: There are actually two routes to becoming an S corporation. You can incorporate as a regular corporation and then make a special election asking for S corporation status. Or you can set up a single-member limited liability company and make the "S" election. If you have the choice, an LLC usually works better because it means less red tape.
  3. Rule 3: Partnerships and groups of investors will usually want to set up a limited liability company, or an S corporation, or a C corporation. While none of these options is terribly tricky, choosing the optimal entity in these cases is tricky. And sequencing the elections correctly is easy to goof up. You want to get able tax planning help in order to pick the best business form and achieve that business form.
  4. Rule 4: If you consult with your attorney for an explanation of the legal reasons for either setting up a corporation or a limited liability company, ask about the difference between tort liability (which is the sort of liability you have if you accidentally drop a hammer on someone’s head) and non-tort liability (which is the liability you have to creditors if your business gets into trouble). A corporation or limited liability company will not shield the owner against liability for his or her own tort actions. It’s also very possible—again, ask your attorney about this—that a corporation or limited liability company will not shield the owner against liability for tort actions on the part of employees.

Related Topics:

 

 

 

 

 

Redmond accountant Stephen L. Nelson, CPA, PLLC provides accountant services for businesses, business owners, investors and other individuals with complex tax or financial affairs in Bellevue, Kirkland, Redmond, Sammamish, Seattle & Woodinville, Washington. All CPAs employed by Stephen L. Nelson, CPA, PLLC are licensed in the State of Washington. Copyright © 2002-2008 by Stephen L. Nelson, CPA, PLLC.
Last modified: October 20, 2008 Site Map