Incorporating a small business is always a tough decision. An online business can be particularly tricky because changes in the business model, the products you sell, and the way you operate can happen so quickly.

Fortunately, if you know a bit of tax law and accounting, you can probably make a pretty good decision based on the size and stage of your eBay business. Here are some suggestions.

The Startup Months: A Straight Sole Proprietorship

People overlook the beauty and benefits of just using a sole proprietorship for a new business. But a sole proprietorship is easy to start. All you need, typically, is an inexpensive business license from the state and maybe from your local city government.

Obviously, a sole proprietorship doesn’t offer you the liability protection that something like a corporation or limited liability company does… but you know what? That liability protection is greatly overrated for small, owner-operated businesses.

In fact, if you do all the work and the people you sign contracts with require your personal guarantee, you may get almost no liability protection from a corporation or limited liability company.

Accordingly, when you’re starting out, go ahead. Just get a business license and get going. You can think about incorporation once you’ve figured out where your business is really headed and what business you’re really in.

When You Reach Healthy Profitability: A Limited Liability Company

After you reach a point of comfortable profitability, you probably want to consider a limited liability company.

A limited liability is very easy to form. Typically, you pay a couple of hundred bucks to the state and then file a simple one or two page form.

Why would you spend this money and go to this effort? A limited liability company offers you the same legal protection as a corporation, but with a couple of interesting benefits.

For one thing, a limited liability company doesn’t require all of the legal red tape and obsessive-compulsive bureaucracy that a regular corporation requires. For example, while a corporation will require a board of directors, board meetings, an annual stockholders meeting, and meeting minutes of all these events, a limited liability company won’t.

And here’s another benefit of a limited liability company that many people don’t appreciate: A one-owner limited liability company operating an active business is treated by default as a sole proprietorship. Sole proprietorship tax treatment keeps your accounting easy. You’ll still be able to file your business taxes on a Schedule C tax form included with your regular 1040 individual tax return.

One other thing: Sole proprietorships provide owners of profitable businesses with a couple of pretty sweet tax benefits. For one thing, a sole proprietorship can hire his or her minor children and pay them wages without their having to pay taxes on the income.

Accordingly, if your kids help you with the packing and shipping? Put them on the payroll! What you pay them becomes a business deduction for the sole proprietorship (that’s you) and saves you taxes. But as long as they do real work and make less than $5,000 a year, they won’t pay any taxes on the money.

A second cool tax benefit is available to sole proprietors: You’ll be able to write off your health insurance expenses. Note that you do need to make at least as much in your business as you pay in health insurance.

Making Big Money: Elect Subchapter S Status for the LLC

And one final idea about incorporating your eBay business. If at some point, your business starts making a lot of money—something rather substantially in excess of what would represent a fair salary to you for your efforts—you need to talk with your accountant about making a subchapter S election. But let me explain.

A tax problem with running a successful business as a sole proprietorship is that you get absolutely hammered with self-employment taxes. Roughly the first $100,000 of your profit gets taxed at 15%. And anything in excess of $100,000 gets taxed at roughly 3%. Note that this tax is in addition to the regular federal and state income taxes you will pay.

If you elect subchapter S corporation tax treatment for your limited liability company, however, you pay employment taxes—the 15% tax and the 3% tax just mentioned—only on the part of your profit that you call “wages.”

Let me provide you with a concrete example. Say you’ve got your ebusiness purring along nicely and you make an easy $90,000 a year. (Congratulations, by the way, if this is the case!)

Furthermore, say you’ve set up the business as a limited liability company but that you have accounted for the business as if it’s a sole proprietorship. In this case, you annually pay roughly 15% of the $90,000, or $13,500 each year, in self-employment taxes.

If you make an S election so that the limited liability company gets taxed as an S corporation, you only pay the roughly 15% tax on the portion of the profits that you call “wages.”

If you can reasonably say that only $30,000 of the profit equals wages—and retail salaries aren’t that high as we all know—you’ll pay employment taxes equal to roughly 15% of the $30,000. That means a $4,500 employment tax bill.

But do you see the tax savings? Making an S corporation election can save you roughly $9,000 a year. That’d be sweet, right?

ABOUT THE AUTHOR:

My friend Seattle accountant Stephen L. Nelson CPA is the author of the bestselling books QuickBooks for Dummies and Quicken for Dummies. He also publishes the Do-it-yourself Limited Liability Company: LLC Formation Kits and the Do-it-yourself Incorporation: S Corporation Kits web sites.