Nearly 17 million Americans -- 16.9 million, to be precise -- are full-time independent workers, according to the latest study from MBO Partners. That's means solopreneurs make up roughly 13% of the full-time workforce in this country. Data from the Internal Revenue Service (IRS) suggests that the majority of these people file taxes as sole proprietors, even if it may not be in their best interests to do so.
The Difference Between Sole Proprietor and Incorporated
The IRS has different classifications for business owners who file taxes. Sole proprietor is the simplest and requires the least paperwork since all you need to do is declare that you're a business owner. Track your revenue via 1099s and your expenses accurately and report the results on Schedule C, add the business income, your other income on From 1040, and -- voila! -- you've met the basic requirements for sole proprietorship.
Incorporating isn't as easy. First, you'll have to file paperwork with the state and get a separate tax ID number. And since a corporation is technically a "pass through" entity in that it never holds cash but rather passes it on to owners, shareholders, employees and vendors, you'll also have separate tax returns that report on how revenue passes through to you.
Usually it's best to hire an accountant to handle these details. How can you know the hassle and expense is worth it? See if any of these three signs apply to your business. If two or more of them do, it may be time to make the switch:
You make too much. Usually it's the quest to lower taxes that leads solopreneurs to incorporate. There's good reason for that. Rather than adding 100% of your profits to your adjusted gross income, you'll take a portion as a salary and the rest as profit distributions that are taxed at a lower rate. Also, if you have a Solo 401k, you can commit some of that distribution income to retirement and claim that as a tax benefit. Say you gross $150,000 in annual revenue. You could choose to pay yourself $75,000 in salary, sock away $18,000 in retirement contributions, and then pay what remains after expenses to yourself as profit sharing. Only that first $75,000 will be taxed at ordinary income tax rates, saving you thousands that would otherwise be due to Uncle Sam.
You need standardized benefits. Most solo operators can get by on little insurance and income when there's no one else to support. That all changes when you get married and have children. At that point, setting up a corporation that will pay for health insurance may make the most sense since 100% of the premium cost -- but not the out-of-pocket! -- can be run through the business as a direct expense. Pro tip: Choose a more expensive upfront plan that limits your out-of-pocket to maximize the potential write-offs.
You're getting legal threats. Incorporating separate business and personal assets can make it tougher for you to, say, lose your home if a client successfully sues your business for negligence. Of course, it's best to assume nothing. Consult a lawyer when structuring your corporation to make sure the assets you care about most are well-protected in the event of a lawsuit.
Finally, it's important to note that while there are several general benefits to incorporating, there are notable differences in the ways you can incorporate. You could have an S-Corp that maximizes tax savings for a single owner, or a C-Corp that allows for multiple owners to split profits as dividends, or a limited partnership known as an LLC. Of the three, the S-Corp generally provides the biggest tax savings while offering the same legal protection as other corporate structures.