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@185 CHAP 2 ┌───────────────────────────────────────────────────┐ │SOLE PROPRIETORSHIPS: ADVANTAGES AND DISADVANTAGES│ └───────────────────────────────────────────────────┘ @Q "Entrepreneurship is the last refuge of the @Q troublemaking individual." -- James K. Glassman The great advantage of operating a new business as a sole proprietorship is that it is simple and does not require any formal action to set it up. You can start your busi- ness today as a sole proprietor -- there is no need to wait for an attorney to draft and file documents or for the gov- ernment to bless them. Of course, you will need a business license in most cases -- and a few states require even a sole proprietor to register in order to do business legally. @IF901xx]Since your business is not in existence yet, the relative @IF901xx]simplicity of starting out as a sole proprietorship is one @IF901xx]key factor you may want to keep in mind when you start up @IF901xx]your firm, @NAME. @IF901xx] @IF115NV]For example, Nevada requires that your sole proprietorship, @IF115NV]@NAME, obtain a license. @IF115WA]For example, the state of Washington requires that your sole @IF115WA]proprietorship, @NAME, be licensed -- @IF115WA](in all but in a very few instances). Another advantage of a sole proprietorship is that you can shift funds in and out of your business account or withdraw assets from the business with few tax, legal, or other lim- itations. By contrast, in a partnership you can generally withdraw funds only by agreement, and in the case of a cor- poration, a withdrawal of funds or property will usually be taxable as a dividend or capital gain and may even violate the state's corporation laws in some instances. @IF121 ]NOTE: Because your business is a corporation, you could in- @IF121 ]cur a subtantial taxable gain if you were to "liquidate" it @IF121 ]in order to turn it into an unincorporated form of business @IF121 ]entity. The taxable gains could either be incurred by the @IF121 ]owner(s), by @NAME, or by both. @IF121 ] @IF121 ]In short, it is much easier to get INTO a corporation, than @IF121 ]to get out of one. @IF121 ] A sole proprietor is the sole owner of his or her business. If married, however, one's spouse will usually have a one- half ownership interest in the business in any of the nine states which currently have community property laws. @CODE: CA AZ NM NV WA ID TX LA @STATE is one of the states that has community pro- perty laws. @CODE:OF @CODE: WS (Wisconsin adopted a community property system of marital property law in 1986.) @CODE:OF As the owner of the business, the sole proprietor is per- sonally liable for any debts or taxes of the business or other claims (such as legal damages resulting from a law- suit). This is one reason why many entrepreneurs who have substantial wealth that could be lost if their business were to fail often prefer to use a corporation rather than a proprietorship or partnership. Unlimited personal liability is perhaps the major disadvantage of operating a business in the form of a sole proprietorship. All of the profit or loss from a sole proprietor's business is taxed to the owner and must be reported on the owner's federal income tax return, usually on "Schedule C, Income (or Loss) from a Business or Profession" of their Form 1040. (Farmers generally report income on Schedule F.) This can be an advantage, tax-wise, since any losses (un- less the losses are from what is considered to be a "pas- sive activity") should be deductible against other income of the owner. On the other hand, if there is a profit, the income may be taxed at a lower rate than in an incorporated business, since corporate rates are generally lower than individual federal income tax rates. The maximum corporate rate is 34% (35% on taxable income over $10 million) vs. a maximum individual tax rate of 39.6% on taxable income of over $250,000. (At certain "phase-out" levels of income, cor- porate rates go up to 39% and individual rates to somewhat over 40%, depending on the number of personal exemptions phased-out, itemized deductions phased-out, etc....) For certain professionals, such as lawyers, physicians, ac- countants, architects, etc., whose corporations are subject to a flat tax rate of 35% if incorporated, a sole proprie- torship is often a much more attractive legal form of doing business. Since the former advantages of corporate pension and profit sharing plans vs. Keogh plans for unincorporated firms are now virtually non-existent, and since professional corporations usually provide little or no protection from malpractice liability in most states, there are fewer and fewer reasons for professionals to incorporate since the 1986 Tax Reform Act went into effect. However, sole proprietorships do have some tax disadvanta- ges. For one thing, with a sole proprietorship you don't have a separate taxpayer entity with which you can split income, as is possible if you are incorporated. (A C cor- poration, by contrast, can still be used to split income between owner and corporation. For example, if the busi- ness generates a $150,000 overall profit, and the profit can be split evenly between owner and corporation by having the owner draw $75,000 of salary for the year, there will be a considerably lower tax bite, taking advantage of the lower tax brackets for both the individual and the corpora- tion, than if all the income is taxed to the owner as a sole proprietor.) Let us look at 3 examples, assuming in each that you are married, your spouse earns a salary of $20,000 a year from a job with an unrelated company, and you have no other in- come, deductions (other than the standard deduction) or dependent exemptions. You and your spouse file joint re- turns. If you had no income, the tax on your spouse's in- come alone would be $1,410 (ignoring any FICA tax on his or her income). ┌───────────────────────────────────────────────────┐ │ EXAMPLE 1: Your business generated an annual │ │ profit of $50,000 in 1992. As a sole proprietor, │ │ you would pay joint income taxes of $10,989, plus │ │ self-employment tax on $46,175 of net S/E income, │ │ or $7,065 ($50,000 - 3825 = $46175) (assuming the │ │ income of the business is self-employment income) │ │ so that the total tax liability is $18,054. If, │ │ instead, your business were a C corporation (but │ │ not a "qualified personal service corporation" │ │ subject to a flat 35% tax rate), and you drew on- │ │ ly a $25,000 salary, the corporation is left with │ │ $25,000 of taxable income, less $1,913 FICA tax │ │ it must pay on your salary, or $23,122 net. Thus │ │ the corporation would pay a corporate income tax │ │ of 15% of $23,087, or $3,463, and your individual │ │ income tax would be $5,160. Accordingly, if you │ │ had incorporated, total tax liability would be: │ │ │ │ Corporate income tax $ 3,463 │ │ Personal income tax 5,160 │ │ FICA (on you and corp.) 3,825 │ │ ------ │ │ Total current tax liability $12,448 │ │ ====== │ └───────────────────────────────────────────────────┘ Thus, in this example, using a "C" corporation to split income would save $5,606, or over 30%, in current taxes, as compared to a sole proprietorship. (Note that even if the corporation were subject to the flat 34% tax rate that was in effect in 1992-- raised to 35% in 1993--there would still be a tax savings of $1,219 in the above 1992 example.) ┌───────────────────────────────────────────────────┐ │ EXAMPLE 2: Let's assume in this example that your│ │ business earns $150,000. As a sole proprietorship,│ │ you and your spouse's total tax would be $39,615│ │ of income tax and $10,658 of self-employment tax,│ │ or a total of $50,273. If you were incorporated│ │ and took out half of the corporate pre-tax profit│ │ of $150,000 as a $75,000 salary, the corporation's│ │ 1992 taxable income would be $75,000 - FICA tax of│ │ $4,529 = $70,471. At the graduated corporate tax│ │ rates of only 15% on the first $50,000 and 25% up│ │ to $75,000, the corporate tax would be $12,618 and│ │ your individual income tax would be $18,978. Ac-│ │ cordingly, if incorporated, the total tax liabil-│ │ ity would have been as follows: │ │ │ │ Corporate income tax $12,618 │ │ Personal income tax 18,978 │ │ FICA (on you and corp.) 9,057 │ │ ------ │ │ Total current tax liability $40,653 │ │ ====== │ └───────────────────────────────────────────────────┘ Thus, in this example, using a "C" corporation to split income would save you $9,620, or nearly 20%, in current taxes, as compared to a sole pro- prietorship. (But note that in this case, if the corporation were subject to the flat 34% tax rate that was in effect in 1992, there would be a $1722 tax DISadvantage if incorporated, versus doing business as a proprietorship.) ┌───────────────────────────────────────────────────┐ │ EXAMPLE 3: Assume this time that you really hit │ │ it big, and that the business made $500,000 pre- │ │ tax in 1992, before paying you a salary of, say, │ │ $100,000. This time (regardless of whether the │ │ corporation is a "qualified personal service │ │ corporation") the total current tax liability is │ │ $169,800 if incorporated, versus $160,113 if you │ │ had remained a sole proprietor. Thus, at this │ │ high income level, being a corporation COSTS you │ │ almost $10,000 in additional federal tax, rather │ │ than saving taxes! │ └───────────────────────────────────────────────────┘ Note that the three foregoing examples only compare CURRENT tax liability. Where a corporation is used to split in- come, the net income that is left in the corporation (net of tax paid on it) MAY result in additional individual tax at some indeterminate time in the future, if paid out as a dividend or in liquidation, or if the stock is sold. Where this double taxation occurs in the near future, the advan- tages of income-splitting in Examples 1 and 2 may be les- sened, or even non-existent, so you should understand that income-splitting with a corporation is largely a matter of tax DEFERRAL and not tax SAVING, for the most part. Even more importantly, note that the Clinton administration has recently raised the tax rates on higher-income individ- uals to as high as 39.6%, versus an increase to only 35% for corporations (still only 34% at income levels below $10 million), which could be a further impetus for many busines- ses to incorporate. As could the extension of the 2.9% Medicare component of the FICA tax to ALL income (not lim- ited to the first $130,200 of income, as in 1992), another Clinton tax change that goes into effect in 1994. Another DISadvantage of sole proprietorships (and partner- ships and S corporations) is that they cannot obtain a num- ber of significant tax benefits regarding: . Group term life insurance coverage; . Long-term disability and accidental death insurance; and . Medical insurance and medical expense reim- bursement plans. To qualify for favorable tax treatment (i.e., deductibili- ty, without the deductible amount being taxed as wages to the owners) in connection with such "fringe benefit" plans, it is necessary to operate your business as a C corporation. @IF117xx](As @NAME is, at present.) @IF119xx]Since your firm @NAME is currently set @IF119xx]up as a @ENTITY, you are losing these benefits.