Should I Incorporate or Stay as a Sole Proprietors

Should I incorporate or stay as a sole proprietorship Schedule C? Does LLC mean that I file as a sole proprietorship , partnership S or C corporation?
By Phoenix Tax and accounting CPA firm Jeffrey I Brooks, CPA, CFP, MBA

Your CPA tax preparer has recommended to you to incorporate but you do not understand why.

Your business is an LLC.

As a Phoenix tax CPA, I answer these questions in a simple manner.

First. What are some of the advantages of remaining as a sole proprietorship?

CPA firm fees are lower than those for partnerships, S and C corporations

1. Employ spouse and deduct medical expenses for the entire family including sole proprietor—see Schedule C Line 14: Employee benefit deduction

2. Employ spouse and deduct fringe benefits like an agri-business medical reimbursement plan.  Although called agri-business, these plans cover all small businesses.

3. Contribute to a retirement plan such as a SEP, SIMPLE or profit-sharing plan instead of an IRA to increase deductible contribution amount

4. Employ a child  under 18 and save income and payroll taxes

5. Maintain a qualified home office and deduct otherwise nondeductible home expenses and commuting mileage

The biggest disadvantage is 100% self-employment tax of 15.3% on ALL bottom line profit!! Ouch!

Incorporating Your Proprietorship

To move your business into the corporate form, you have to formally transfer the assets to the corporation in exchange for stock.

One common mistake I see is that stock is not paid for.

Another common mistake is loan the corporation in the form of assets transferred or cash but failing to establish a formal promissory note with interest.   Another common error is failing to pay the interest.

Although IRS has been lax in enforcing the Tax-Free Exchange rule, it doesn’t mean that IRS will not enforce this rule.  For example, you and your business associate decide to combine each of your sole proprietorships into a corporation and you each will own 50%. You each have large receivables.  Since you do not qualify for section 351 tax free transfer, the transfer will trigger a taxable transaction…OUCH!

So what can be done?  It is too complicated to explain here but it can be done!

So what does it mean “If you control your corporation, your transfer of assets to the corporation in exchange for stock is tax-free?”

“Control”  means that immediately after the exchange, you own at least 80 percent of the combined voting power of all stock, and 80 percent of each class of stock without voting rights.

Your corporation is a separate entity from you. When you create a corporation, you essentially create a new person for tax purposes.

The corporation cannot use your personal assets (and you cannot use the assets of the corporation) without consequences, just as you cannot use another person’s assets without compensating the person for that use. So if you need money, then the corporation (not you) can pay you via a payroll check, a distribution/draw/dividend.  Never ever write a personal check, transfer or wire out of the business.

If the IRS finds you are commingling your personal affairs with corporation in a non-arms length transaction, the IRS will decide on a reallocation, and you can absolutely bet that the new allocation is not to your benefit.

Another Warning that I have seen ignored:  You will recognize gain if the liability exceeds the basis of the property you transfer or if the liabilities give rise to a deduction when paid, such as trade accounts payable or interest. IRC Section 357(a), (c).

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About Jeffrey Brooks

Jeffrey Brooks, CPA, CFP, MBA since 1976 has specialized in helping clients save significant taxes, help businesses increase their cash flow, revenues and profits while increasing their control and satisfaction. Jeff and his accounting firm sincerely cares about the happiness of his clients.

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JBrooks Wealth Advisors, PC.

Certified Public Accountant
Address: 4647 N 32nd Street, Suite B245
Phoenix, Arizona 85018
Phone: 602-292-2009