You operate out of a corner of your house. A coffee shop is your conference room. Should you turn yourself into a corporation?
I decided at the end of 2006 to form 89 Peanuts Inc. (the name is an inside joke) with the assistance of Tom Bartlett, a registered tax preparer and certified financial planner with Royal Alliance Associates Inc. Bartlett told me incorporating makes sense for anyone whose annual net profits exceed $25,000.
“It’s a way of reducing the corporate income without reducing the personal income,” he said.
Some advantages of incorporating vs. staying a sole proprietor:
BIGGER IRA CONTRIBUTIONS
A sole proprietor can contribute up to $5,000, pretax, into an IRA, and as much as 13.04 percent of net income into a simplified employee plan (SEP) or a savings incentive match plan for employees (SIMPLE) IRA. But people who have incorporated can salt away up to 25 percent of income, with a limit of $49,000 in 2009.
A sole proprietor who earns $60,000 in a given year will pay about $9,500 in Social Security taxes, but the amount is just $4,500 for an S corporation owner who pays himself or herself $30,000 a year, and pays a state corporate income tax.
A monthly allowance tied to a percentage of gross income can be set up to pay for automobile and entertainment expenses.
Incorporating means being able to write off premiums for medical, unemployment and life insurance, as well as file a claim against the corporation for unemployment, since unemployment taxes are paid along with state payroll taxes, based on the salary portion of one’s earnings.
It’s not necessary to hire a lawyer to incorporate. Low-cost services such as LegalZoom.com can be used to complete the necessary paperwork and receive a corporate seal from the state where the corporate entity is established.
People who incorporate must file either as an S corporation, C corporation, limited liability company (LLC) or limited liability partnership (LLP). Bartlett says the decision hinges on state corporate tax laws and the potential need for greater legal protection (forming an LLC can lower liabilities).
Many freelancers opt to form S corporations, which pay no federal corporate income tax.
All earnings go directly to the corporation’s shareholders, even if it’s a sole shareholder, and are reported on an individual’s income tax return. Bartlett says an S corporation and LLC are not subject to Social Security taxes and issue K-1 forms for profit distributions. C corporations pay wages and dividends. LLPs are partnerships and not practical for a freelancer.
In order to avoid penalties for under-withholding or underestimating quarterly tax payments, corporate owners will need to pay in at least as much as their previous year’s tax bill and can pay more based on projected net earnings. While this also is true for sole proprietors, Bartlett points out that corporate income is often omitted in estimating a new year’s total income.
Not all freelancers will want to incorporate. Daniel Steven, a publishing attorney, cautioned in an article on PublishLawyer.com that “incorporating also can be expensive and ineffective.” The cost of incorporating can range from $25 to $100, depending on miscellaneous state fees, according to Bartlett. But there could be other costs and greater complexity for some prospective business owners. In my case, for example, the initial tab was $820 when factoring in fees associated with receiving legal assistance from LegalZoom.com, setting up a post office box in an unincorporated area of Los Angeles to avoid also having to pay a city tax, and having my initial corporate tax return prepared.
Steven also noted that forming a C corporation, while useful for letting you pay yourself, also forces you to withdraw profits as stock dividends. These face double taxation at both a corporate and personal tax rate, while the IRS can force these business owners to withdraw funds deemed excessive, pay a dividend tax and assess a penalty — a scenario that’s avoided for S corporation owners.
“Most freelance writers are usually better served worrying about finding new clients or finishing the next book rather than incorporating,” Steven wrote.
But for me, I’m more in control of my retirement plans and can earmark money for these savings vehicles that otherwise would have gone into FICA taxes paid under Social Security. At the same time, I’m insured for Social Security death benefits and can receive unemployment insurance by paying into the system.
I have better legal protection. And I have the intangible advantage that prospective clients may take me more seriously.