Should IT consultants incorporate?

Forming a corporation essentially means organizing a business to be chartered by the state; as a result, the company is granted legal rights as a separate entity from its owners, including the issuance of stock shares that are easily transferable.

One of the most common types of corporations for small businesses with less than 75 shareholders is the S-corporation, which allows individual shareholders to pay tax on company profits via their personal tax filings. This avoids a “double tax” on the company, which would otherwise have to pay tax on its profits and on shareholder dividends, and shields company owners from the businesses’ liability. A more flexible form of corporation, the Limited Liability Corporation, authorized only in certain states, can also shield owners from liability and give some of the tax benefits of an S-corporation, without requiring the company to bend to the same restrictions.

In most cases, the tax relief a sole proprietor might experience forming a corporation is minimal, but the change in status does offer protection and benefits not extended to a sole proprietorship with a DBA (Doing Business As) designation, particularly for IT consultants hoping to grow their businesses and attract high-profile clients. The question of whether to incorporate boils down to four issues.

1. Liability
When Sharon Troth first accepted a handful of clients while working full-time at another job in Nashville, TN, she didn’t imagine that in just a few years she would incorporate into her own business. Troth, now president of net images, inc., a New York-based IT consultancy firm specializing in Web site interface and design, said the decision to incorporate came after four years of operating as a sole proprietor. As her business grew from 15 clients to over 80 and she hired several part-time employees, Troth sought corporate status as a way to limit her personal liability.

“If they’re in a business where liability is involved and it’s important to protect their own assets, then I definitely recommend incorporation for protection,” Troth said.

For many consultants, the issue of incorporation arises as a consultant’s contracts increase in value, said Catherine Berlin, a lawyer with Altreuter Habermehl in Buffalo, NY.

“The larger the dollar amount and the more prestige riding on the result, the less likely someone is to tolerate a failure to meet a critical deadline or accept a nonconforming result,” which could place an IT consultant in litigation, Berlin said. She also noted that, because the courts and lawyers have placed more emphasis on seizing tangible assets, the value of intellectual property as an asset has gone unrecognized for now. She says, however, that litigants will begin more aggressively targeting intellectual property as well. Incorporating can offer consultants greater protection against such claims.

“Less tangible goods, such as designs, programs, [and] business identity images can be just as valuable to a customer or your competitor,” Berlin said. “If a business dispute rises to the level of a lawsuit, and the IT person loses the fight, then all these assets, to the extent they have a value to someone else, may be fair game for an auction or seizure.”

In fact, IT consultants who do any work for another business place their personal assets at risk if they aren’t incorporated, said Jason Savlov, a Los Angeles-based attorney specializing in technology and entertainment issues.

“If you are consulting for a business, then you risk exposure of personal liability—anything from managing a project to producing code for a business that could create delays, which results in lost profits, fines, or extra expenses for the business,” said Savlov.

“I have a line of credit that is solely for the business and has helped give me a cushion for the slower months,” explained Troth. “I had an existing relationship with the bank I use for business, so the line of credit is just about the same as a personal line of credit, just now it is in the business’s name.”

Discount purchasing and the ability to qualify for corporate medical and dental programs is also a possibility when a business incorporates. As a sole proprietor, Troth had to pay on individual health insurance and was unable to provide any insurance for her employees. As a corporation, Troth may be able to insure her employees, though she has found thus far that she will require more than three employees before the company is eligible for discounted health insurance.

3. A good accountant
Incorporation demands that you have a much closer relationship with your accountant. As a company president or primary shareholder, you must still file personal income tax forms, but because the paperwork is complicated, your accountant will file a series of tax forms on behalf of the corporation. The forms filed each quarter and annually are different from those filed by a sole proprietor. Strict record keeping is required on your part, obviously, as well as communication with your accountant.

The amount of tax a corporation pays may not vary greatly from the tax on a sole proprietor, though it can be a bit more, said Kelly Swartz, a CPA and sole proprietor in Nashville, TN. She said that most states require corporations to pay some sort of franchise tax as well as an excise tax.

“You’re certainly not paying any less tax,” Swartz said. “If anything, you’re paying more tax because you’re going to have to pay certain corporate taxes.”

In some cases, the taxes remain similar but come from a different source. For example, as the company president or main shareholder, you would no longer be required to pay a self-employment tax. Reserved for sole proprietors, self-employment tax collects the remaining 15 percent due on your personal income to compensate for Social Security, Medicare, and Medicaid that an employer would traditionally pay. The corporation is now responsible for that tax.

Despite the corporate status, Troth says all the taxes come out of virtually the same pocket.

“Now my company withholds a certain amount from my paycheck, and I have to pay that to the corporation, and the corporation writes the [tax] check,” she said. “Previously, I had to pay self-employment taxes, and it was a personal check I wrote. But they both hurt the same.”

“Incorporation can give you a bit more credibility, especially if you’re doing something for a large corporation and if they want to work with a real company vendor,” she said.

Troth credits having “inc.” at the end of her company’s name with being on the final lists of two major client projects for large firms, noting that it helped her business appear to be larger and to have greater access to resources.

In reality, consulting firms like Troth’s often use subcontractors to ramp up for large projects, but having a corporation can give the impression of a staff and a company with adequate resources to meet client needs. In contrast, an individual consultant’s resources could be questioned.

Bottom line
When should IT consultants incorporate? Berlin believes that when starting a company, incorporating might not be the first order of business, noting that some liability can be removed with a “strong consultancy contract with favorable and tight liability and indemnification clauses” and asset insurance.

According to Berlin, this holds true if the IT consultant doesn’t hire employees. Instead, she suggested consultants should be focused on developing a client base and a product and creating advertising and marketing campaigns. “How to protect yourself and your assets, if these efforts pay off, is something that can be done at a later stage,” said Berlin. “It becomes an enviable problem to have to address.”

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