Glad About Incorporating (Well, Mostly)

by Joe DiNunno

Over the years I’ve had many conversations with computer consultants about the merits of incorporating. I spent seven years as a consultant operating my business as a sole proprietor before incorporating two years ago. Although many consultants favor incorporation, the decision to incorporate is not as clear-cut as some make it sound. What they fail to mention is how much more work it requires. While I’m happy about making the change, there have been days when I appreciate the simpler life I had before opening “my own company.”

Advantages of Incorporating

First, let’s review some of the advantages of incorporating. The benefit that convinced me to incorporate was reducing my annual self-employment tax. Depending on your income, and the approach you and your accountant are comfortable with, you could reduce your taxes by thousands of dollars a year. For many, this is reason enough to make the switch.

Limiting your personal liability is also a frequently mentioned advantage. Although incorporating can protect your personal assets from creditors, you’ll find that obtaining a corporate credit card, or a small-business loan, may still require you to be personally responsible for these debts. From a legal point of view, incorporating doesn’t prevent someone from bringing a lawsuit against both you and your company. Either way, you may want to consider errors and omissions insurance, though I’ve found that most consultants don’t carry it since it is rather expensive.

In some cases it may be easier to market your services if you are incorporated. Some potential clients are more comfortable calling a “company” than contacting a “person” to help them with a project. In addition, several of my colleagues have found that many brokers will not work with you as a 1099, but will hire you on a corp-to-corp basis.

Drawbacks of Incorporating

Now that we’ve considered the advantages of incorporating your business, let’s look at some of the drawbacks. Before you do anything official, find a good accountant with experience working with consultants. Corporate tax returns are quite a bit different from the typical Schedule C. Regulations work differently when you are an employee of your own company rather than being self-employed. Even with the help of an accountant, it’s easy to overlook one of the many new forms you are required to file.

When I did that, I discovered that the IRS is much quicker to assess a fine than to review your request to waive that penalty. Although I’m happy to say that a refund check showed up in the mail several months later, when I look at the time I spent getting that money back, the payoff was much lower than my regular hourly rate. While working with accountants should keep you out of trouble, keep in mind that paying for their services cuts into the money you are saving in taxes.

One of the big frustrations with having an incorporated business is that administration takes considerably more time. You must hold your own annual meetings and maintain a record of all corporate actions, even if you are the only director, shareholder, and employee. On the other hand, I’d suggest using a payroll service to take care of the additional paperwork required for a corporation, especially if you have employees. When you consider what it costs you in time, you are much better off paying someone else to do this work.

Although taking some of your income as a distribution rather than salary will reduce your self-employment taxes, there is one big disadvantage. If you want to put away as much as possible into a retirement plan, like a SEP or Solo 401(k), incorporating can cut the amount you are allowed to save almost in half. Since you can only contribute a percentage of your “earned” income to a retirement plan, this approach reduces the maximum amount you can deduct on your taxes. In my case, even though I paid less in taxes, some of the savings came at the expense of having less money available for retirement contributions.

Is Incorporation Right for You?

There are advantages to both sides of this issue, so use this information as your starting point. Let me emphasize that you should talk with an accountant before making your decision. You may also want to consult a lawyer, but that isn’t required for you to incorporate. You can pay a service to do it for less money or check online with the appropriate state agency to file the paperwork yourself. Is incorporation right for you? Evaluate your situation and then make your decision.

Originally Published in Contract Professional Magazine in April 2001