Corporation vs. Sole Proprietor
Personal Liability
First remember a corporation is usually formed to avoid personal liability for its owner. A
sole proprietor is completely responsible for all of his/her employees and any problems that may
arise from a law suit. Said another way, a sole proprietor's home and other personal assets are
subject to attachment if there is a law suit. In a corporation, if all the corporate requirements have
been met, the only thing a potential plaintiff can get is the assets inside the corporation.
Having said that, for professionals, doctors, dentists, lawyers and CPA's etc., most states have
laws that provide, in the case of malpractice, the professional is
personally responsible (not the corporation). However,
if the avoidance of personal liability is the main purpose of the corporation a doctor, dentist,
lawyer, CPA etc. can avoid the malpractice of another (doctor, dentist, lawyer, CPA, etc.) if he or she
has a professional corporation. For example, if 2 doctors had a partnership and no corporation(s)
and one doctor committed malpractice both doctors would be liable. But if two doctors had a
partnership and one or both were professional corporations then only the doctor committing the
malpractice would be liable (not both).
Of course doctors, dentists, lawyers, and CPA's are shielded from other types of law suits
(non-malpractice suits) with their professional corporations. For example, if the doctor, entered
into an office lease with his professional corporation as the lessee and he could not make the
lease payments only the corporation would be liable for the broken lease, not the doctor's
individual assets.
Tax Aspects of Corporations
Corporations are separate taxpayers. They have their own taxpayers identification number
(similar to an individual's social security number). They must file a corporate tax return each
year. If the corporation is a C corporation it must pay taxes on its net profits. The tax rates of
an individual with the 2001 law are 10% to 35% (after 2006) for a C corporation they are 15%
to 35% (see Internal Revenue Code § 1 and § 11). At first blush, it appears a C corporation and
an individual are taxed the same, but they are not.
First, as any elementary financial planner will tell you, '...there is double taxation with a
C corporation...'. Well, yes, in theory that is possible. What he/she means is a corporation grosses,
say, $100,000.00 for the year, and it pays $50,000.00 in various expenses, and pays a salary of
$40,000.00, leaving a net of $10,000.00 ($100,000.00 -$50,000.00 -$40,000.00 = $10,000.00).
With $10,000.00 left the corporation pays tax of $1,500.00 on the $10,000.00 (15% rate) and
now has $8,500.00 remaining. The owner of the corporation wants the $8,500.00, so pays
himself a dividend of $8,500.00. The financial planner will tell you '...see now the owner has to
pay tax on the $8,500.00 he just received and the money is taxed twice, once at the corporate
level and once at the individual level...'. Well.... yes but. Your salary or bonus is an expense of
the corporation and, in the example above, if you gave yourself a bonus at the end of the
corporate year of $10,000.00 you would have $0.00 corporate tax and would only pay tax once at
the individual level on the $10,000.00 (the amount of individual tax you would pay would
depend upon your tax bracket [10% to 35%]).
Another thing to look at before I explain other tax attributes of corporations is IRS audits.
Sole proprietorships get audited all the time! Remember, the IRS tax schedule for sole
proprietorships provides a number of suggested categories for deductions. If you prepared your
own taxes, and finished with the forms and realized you were going to owe a lot of money to the
IRS, wouldn't you maybe "review" your return to see if you "forgot" some deductions? The IRS
is aware of this, and therefore audits sole proprietorships frequently. If you have a sole
proprietorship you are more likely to be audited.
C corporations can have fiscal years. Us as individuals (and therefore sole
proprietorships) are calendar year taxpayers, meaning our "books" close for the year on
December 31 and open new on January 1 each year. New corporations can choose their fiscal
year. A C corporation could close its books on January 31 and open new on February 1 each
year (there are some restrictions to this, but most of them are surmountable by careful planning
[see Rev. Proc. 87-32 for further details]). This ability provides opportunities for some planning.
What if, in our example above, you had a C corporation with a fiscal year ending on January
31 (thus beginning February 1) and on January 30 you gave yourself that $10,000.00 bonus
(personal income) from your corporation. When would you have to pay taxes on it? Tax on the
personal income would be due the following year on April 15th, giving you a whole year to
invest it.
Medical Reimbursement Plans
Anything a corporation spends on medical for its employees is a full deduction by the
corporation (you would be an employee of your corporation). Not so with a sole proprietorship.
Pension plans are available in a wide variety of corporate pension plans, but not so with a sole
proprietorship. And, as an added benefit, a corporate pension plan is untouchable by creditors or
bankruptcy or the IRS (just ask O.J. Simpson, who is living off of his corporate pension plan). On the other
hand, Keogh-type pension plans for sole proprietorships are not exempt from creditors or the
IRS.
A corporation is a separate taxpayer, it can lease property from you. For example, you
own your own medical building and want to lease it to yourself but take all of the deductions for
you personally. You can do that if you are a corporation. But, you cannot lease your own building
to your sole proprietorship. Nor, for that matter, may you lease your own car, medical equipment
etc. to your sole proprietorship. The reason, of course, is that you and your sole proprietorship are
considered one and the same taxable entity by the IRS.
Disclaimer: The information in these web pages has been prepared as a
service to the community and does not constitute legal advice. This
information may not apply to your situation particularly if you do
not live in the state of California. Do not make legal decisions based
on this material. Consult an attorney in person before making any
important legal decision.
