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Four Things You Should Know Before
Incorporating Your Quilt Shop
by Mark Smith, CPA, Attorney at Law

Have you been told by your CPA or a friend or business acquaintance that you should think about incorporating your quilt shop, and wondered whether it was a good idea? If you are like most quilt shop owners, you are currently operating your business as a sole proprietorship - that is, you and your business are one and the same as far as the IRS and the legal system are concerned.

The incorporation of your quilt shop can potentially put thousands of extra dollars in your pocket as well as greatly enhance your legal liability protection. Before you change your business structure however, you should be informed about the choices and consequences that will follow. Here are a few questions which are common to business owners who are thinking about a change for their business.

1. What are the different types of business entity options available?

There are two potentially useful options available to your quilt shop if you change your sole proprietorship to another form of business - an "S" corporation or a limited liability company (LLC). Two other common forms of business organization are "C" corporations and partnerships; however these are generally a poor idea for most small businesses because of either tax or liability issues.

An S corporation is a business form which has a separate and distinct legal existence apart from its owners (the "S" is from the chapter in the Internal Revenue Code that sets out the tax rules for running an S corporation). In theory, every corporation consists of three groups: those who direct the overall business, called directors; those who run the business from day-to-day, called officers; and those who invest in the business, called shareholders. In the case of a small business, however, a single person can be, and often is, the sole shareholder, director and officer. S corporations, like LLCs, are called pass-through entities. This simply means that the business itself does not pay any federal income tax, but passes on all of its earnings to you to be reported and taxed on your personal tax return.

A limited liability company is a business structure that is taxed like a partnership, but gives its owners the same limited liability as a corporation. There are pros and cons to having your business taxed as an S corporation or an LLC, and they are discussed in more detail below. In general, if you do not have a co-owner in your business, you will find that an S corporation offers the most benefits, while an LLC may be of use if you own your quilt shop with another partner.

2. What tax advantages are there to forming an S corporation?

The important thing to keep in mind when you consider this question is that you pay two types of federal taxes on the money you make in your quilt shop: (1) income tax, and (2) self-employment tax (sometimes called FICA or Social Security/Medicare tax). If your quilt shop is currently a sole proprietorship, you will not (except for a few minor exceptions) pay any more or any less income tax by forming an S corporation or an LLC. Thus, you would not want to incorporate as an S corporation if your goal was solely to reduce your income taxes - there will be no benefit to you.

When it comes to self-employment taxes, however, the situation is very different. The government assesses self-employment taxes at 15.3% of your net business income. Let's say you had gross sales of $120,000 in your quilt shop last year, and after subtracting your cost of goods sold and other business expenses, you had a net profit of $30,000 left over. You would have owed $4,590 in self-employment tax ($30,000 x 15.3%). Note that this is in addition to your income tax on the $30,000.

If you had operated your business as an S corporation however, you would have been an employee of your corporation (it no doubt seems a little strange that you are "employing" yourself, but that's the way it is treated if you have a corporation.) If you paid yourself a salary of $18,000, and took the remaining $12,000 as a "distribution," you would only need to pay FICA tax of $2,754 on the salary of $18,000. The IRS does not require you to pay FICA tax on the $12,000 you paid yourself as a distribution, with the result that your net tax savings total $1,836! The more money you make in your quilting business, the more you save. I have clients who every year put over $7,000 extra dollars in their pocket alone, simply because they have incorporated.

It is important to note that FICA tax savings are available only to S corporations - because of the way the tax code is set up, LLCs are not eligible.

3. Can I limit my liability by forming an S corporation or an LLC?

One advantage of both S corporations and LLCs is that they are considered to be separate and distinct legal individuals from yourself (sometimes known as a "limited liability entity"). What this means is that although someone may sue your business and win, they will only be able to take your business assets to satisfy their lawsuit - not your personal assets such as your home, car, personal savings and retirement accounts.

This protection can be very valuable. For example, if one of your employees is making a delivery and has an accident which is the employee's fault, the other driver could sue your business and take your business assets. However, if you are operating as an S corporation or LLC, they would not be able to sue you personally and take your home or other personally owned assets from you.

As a quilt shop owner who has employees (even if it is only one part timer) you are putting your family's personal assets at serious risk if you are operating as a sole proprietorship, since employees are the number one source of legal liability for small businesses. On the other hand, if you are a one person shop with no employees, the legal protections of an S corporation or LLC may be of limited value to you. (As mentioned above, there are still significant tax reasons why you may wish to incorporate.)

4. How do I choose between an S corporation and an LLC?

If you are the sole owner of your business, then you will most likely find that an S corporation is your best choice, due to the tremendous savings in self-employment taxes it offers (as noted above, an LLC will not help you on this point). An LLC may be a good choice for a quilt shop you run with another owner, as it allows you more flexibility in dividing up profits and losses than does an S corporation. Choosing a new business structure is a decision that should be made carefully, and requires you to consider other factors in addition to taxes and legal liability.

Before changing your business structure, you should consult with a trusted business advisor such as your CPA or business attorney to get advice specific to your particular situation.

(c) Mark Smith - All Rights Reserved

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