In talking with non-incorporated small business owners that are not clients of our firm, I often ask why they have not formed an S-Corporation for their business. A common response I have been hearing is that their accountant or CPA told them that they had not reached the “breakeven point” for incorporating. Some have even told me that their accountant or CPA actually quantified the “breakeven point” at a specific sales dollar amount.
Now, while I agree that some smaller businesses are better off as sole proprietorships, I disagree with this type of broad recommendation and concentrating too much on income as your deciding factor on whether to incorporate or not. There are many other factors and benefits to consider…
1) Reduction of Audit Risk
Many often overlook this benefit of incorporation because they think it will never happen to them or they just don’t like thinking about it; however, it is definitely a benefit of forming a corporation and it is especially beneficial for industries with high audit risk like construction and restaurants.
Last year the IRS hired a large number of auditors in Portland and cities around the country and really ramped up compliance audits. Having been through several audits of sole proprietorships reported on a Schedule C in the last few years, I have witnessed first hand the the inconvenience and cost related with going through an audit. It is very “taxing” mentally, emotionally, and physically even when you have a CPA or lawyer to represent you, so I would definitely consider these costs when considering incorporation if you are in a high risk industry.
I am not suggesting that S-Corporations are free from audit risk; in fact, they have their own audit issues like reasonable compensation and excess distributions. Rather, in general the audit risk is simply lower than with a businesses reported on Schedule C. Also, corporations require much more detailed records and reporting, so usually the chances of errors are much lower. I have seen some accountants make some fairly material errors simply because it was a Schedule C and a balance sheet was not required.
2) Limitation of Liability
Many business owners overlook this benefit as they believe they are protected by their insurance, or they simply think it will never happen to them. However, in today’s litigious society with lawsuits abounding, you need to protect your personal assets and a corporation clearly separates corporate and personal assets and limits your liability in most cases to the assets of the corporation. You should always seek the counsel of a lawyer regarding the specifics of your circumstances; however, if a business owner is in a field that has high risk of lawsuits, then an S-Corporation could really minimize that risk as opposed to staying a sole proprietor and running the risk of facing a lawsuit that can reach your personal assets.
3) Better Financial Documentation
The fact that you have to report more financial data to the IRS and keep more accurate records is often looked on as a downside to S-Corporations; however, I have seen an upside with this in the S-Corporation clients I have worked with over the years – the S-Corporation pushes you in the direction of better bookkeeping.
Sole proprietorships tend to have very poor books and records primarily because they do have to report a balance sheet. Often, sole proprietors submit a list of expenses, a box of receipts, or even worse – an inter-mingled mess of business and personal expenses that you are magically suppose to be able to separate. This lack of internal organization and separation of the business entity leads to poor decision making as there is nothing close to a financial statement that the business owner could review and base decisions on. As a CPA, I see this all the time and you have to wonder how people stay in business like this.
It may take a few years after incorporation, but most small S-Corporation owners have to start keeping better records. Loans have to be tracked and reconciled, shareholder activity has to be documented and recorded accurately, payroll has to be processed, and reimbursements have to be made for expenses paid personally. Over time, and with the help of software, this becomes easier for the business owner and eventually they are using the internal financial statements and reports in business decisions and planning. Yes, it is much more costly and time-consuming, but I see the S-Corporation as the much needed motivation to force us into effective business operation as financial reporting is vital to a successful business.
4) Wage & Payroll Tax Considerations
Another factor you have to look at is the industry the business owner operates in and the level of wages that would be considered “reasonable” for work that the business owner performs. In some industries and in some positions, an average, reasonable wage that you would find in a salary guide is going to be much lower than others – which means greater tax savings with an S-Corporation since you only pay the equivalent of self-employment tax on the wages paid to the shareholder. A dentist or doctor is going to have to have a much higher wage than a contractor or a consultant, so again – you cannot look purely at a sales volume breakeven point.
You also have to look at the number of employees that the business will have and the turnover. With the Oregon Employment Department, if you only have minimal number of employees and low turnover, then after two years you could qualify for the lowest state unemployment rate – which is now at 0.7%. Savings from incorporating will be much greater than a business owner with high turnover .
The Bottom Line
I admit, I am quite partial to the S-Corporation; however, it is not right for every business and situation. However, the most important thing to remember with incorporation or any tax decision is to consider more than just the tax dollar savings. There are always many other factors to consider and I strongly recommend talking with your accountant or CPA and have them walk through all the costs and benefits with you. If you are looking for a CPA in the Portland area, we would be love to talk to you. www.PandGCPA.com