According to a IRS statistics, those who incorporate their business is 10 times less likely to be audited than those who run a business and report that income on a Schedule C form. Schedule C is for sole proprietors who report that income directly to their personal 1040 tax form.

Now, correlation does not equal causation. That is for certain. So all we can do is guess as to why this is. Is it possible that the IRS algorithm’s feel that those who report income on the Schedule C are more likely to hid income, or take inappropriate deductions? It’s possible. Also, is it harder to do these things when the Corporation must file its own tax return? That is also highly possible.

When you incorporate your San Diego small business, you will most likely elect to tax the corporation under Subchapter S. This makes it a separate entity. You must file a tax return for the Corporation, then report the results of that onto your own tax return. Most of this must be done by an accountant or CPA. It is therefore not an unreasonable assumption to believe there is less risk of abuse here, although the risk still remains.

Oh and you also get increased asset protection as well. Not a terrible side effect.

Small businesses are the IRS favorite targets. They are ripe for abuse. Unnecessary deductions, excessive deductions, hidden income here and there. Sure why not, who is counting anyways.

So as a small business you must do your best to keep a low profile from the IRS so you don’t risk being on the receiving end of an audit. According to figures from the IRS, rates of audit for Schedule C filers can reach as high as 3.68%. The rate for Corporations under Subchapter S? 0.30%.

That is amazing and quite surprising to see such low rates of audit.

So whether it’s causation or just plain old correlation, it appears that incorporating your business may lower your audit risks substantially.

A California Court of Appeals has determined that being a sole shareholder does not make you an employer. This is important for cases involving the California Family Rights Act because recovery under that act is only available from the employer. The employer in that case being the corporation. Plaintiffs argue that the shareholder should also be personally liable since he exercised control over them, and also under a theory of alter ego. The court rejected plaintiffs argument:

In this instance, where a third party seeks to hold the sole shareholder liable for the wrongdoing of the corporation, an alter ego theory is the appropriate way to determine whether the shareholder is liable.

The opinion goes on to say that in California a corporation (or other entity for that matter) is normally considered separate and apart from any shareholders, employees, officers etc. Only in very narrow circumstances will they deviate from this, and only in the interest of serving justice.

If you really like to torture yourself you can read the whole opinion here Leek-v.-Cooper

Par value is the minimum price that a share of a corporation may be issued for, set by the company issuing the shares.  Par value is usually unrelated to market value.  You may see par value at $0.0001 a share, which means the founders can issue themselves 10,000,0000 shares for $1,000.

The value is set arbitrarily, and for most small businesses may not be needed at all.  California does not require par value shares, so you do not need to set par value unless required to do so by Federal or other regulations and statutes.    As a matter of fact, California does not distinguish between par and no-par value stock.  California Corporations Code 205. 

So you decided that you would like to protect your personal assets from that new or existing business you operate.  But now you cannot decide between a corporation (most likely an S Corporation for smaller businesses) or a limited liability company.  Maybe you were even thinking about using a document preparation service like Legal Zoom but were afraid you might choose the wrong entity for business.  There really is a "one size fits all" approach for your business, and you need to decide carefully which path you will choose.

Of course, once you choose a form of entity your work is not finished, as strict formalities are required and compliance is crucial to preserve any protection the entity provides.  But the following advantages and disadvantages should help you decide.  As always, you may want to consult an attorney to decide which factors are more important for your particular situation.

S Corporation

     Advantages

• Shareholders enjoy limited liability.
• Ownership interests are freely transferable (subject to S Corporation restrictions).
• Existence unaffected by the death of shareholders or transfer of shares.
• Centralized management.
• Pass through tax treatment (as opposed to double taxation of C Corporations)
• Losses are available on the shareholders’ personal income tax returns and can offset other income (subject to the "at risk" and passive loss rules).

     Disadvantages:

• Formalities are required for organization and operation, more so than LLC
• Qualification is required for doing business in other states.
• Regular reporting is required.
• Strict qualification rules must be met on a continuing basis, which among other things limit the number and types of shareholders.
• The distribution of property by an S corporation to its shareholders is generally a taxable event for income tax purposes.
• Transfers of shares may be subject so securities regulations

Limited Liability Company

     Advantages

• Members enjoy limited liability.
• More flexible than S Corporations
• No limitation on the number or types of members.
• Centralized management is available if an LLC is manager managed.
• Assuming LLC is taxed as a partnership, pass through taxation.
• Losses are available on the members’ personal income tax returns and can offset other income (subject to the "at risk" and passive loss rules).
• Special allocations may be made for income tax purposes.
• Disproportionate distributions may be made to members.

     Disadvantages:

• Formalities are required however they are less onerous than S Corporations
• Regular reporting is required.
• Termination results from the death, disability, or withdrawal of a member under the laws of some states.
• Interests are not freely transferable.
• Business profits are taxed as income to the individual members and, as a result, may be subject to self-employment tax as well as income tax.
• Transfer of interests may be subject to securities law regulation.

This would seem very obvious but I’ve had some business owners come to me after an incident has occurred looking to incorporate their business (or organize a limited liability company).  They have heard about corporations or LLCs and that these entities protect their personal assets from any business liabilities.  Yet they have not taken that first step to decide whether or not they should incorporate their business.

Sometimes they attempt to incorporate or organize too late. Usually after a significant event has occurred, such as a dispute over a debt arising. Or worse yet, after lawsuit has been filed.  If the entity has not been formed when the liability arises, forming the entity afterward will not do much to help your situation.  In addition, if you form an entity with the express purpose of placing assets beyond the reach of creditors, and a significant debt or liability had just been incurred, this might be viewed as a fraudulent transfer. California has the Uniform Fraudulent Transfer Act to address this very issue, and there may be civil and criminal penalties involved.

So take that first step before you incur any debt or liabilities.  Maybe an entity is not right for your business.  Each business is different and you should really examine your particular facts and circumstances before deciding whether to form and entity, and which entity to choose.  But you should definitely perform that examination, sooner rather than later.