Thinking about leaving our present position and heading out on your own? Maybe you’ve already done that and your business has grown significantly over time and you’re wondering if you have enough legal protection. Whatever the case, the business needs a legal structure, even if it’s as a sole proprietor.
There are a number of structures available to you. The decision should be based on a number of criteria, including tax treatment, personal liability, and future flexibility. Please be very careful and consult an expert for detailed advice and state registration requirements. Here’s a brief overview.
The easiest is the sole proprietorship.You own the business and if you have not set a structure, by default you are a proprietorship. Your net income is reported on Schedule C of your 1040. Your earnings are taxed as ordinary income. In addition, you are required to pay the self-employment tax, which effectively increases your social security taxes. (If you are salaried in a company, then the employer pays the excess, in fact more than the excess you would pay.)
When operating as a sole proprietor, any liabilities by the proprietor are personal. That means that if someone is owed money, they can get a judgment against you personally. This also included product liability claims. Without question, this is the single biggest reason to look into other structures, even as a one-person independent contractor.
You can form a corporation, either a C or S Corp. That will shelter you from any personal liability. Of course, there may be some modest charges to set up the legal structure. The C Corp files corporate tax returns and pays income taxes at the corporate rates. Any money that you want to take from the C Corp (other than salary) is taxed as dividends. In theory, think of it as double taxation. You only have the after tax income to distribute, then you pay personal income taxes on the dividends.
The S Corp is a pass through from a tax perspective. It still must file a business tax return, however, the income passes through to the S Corp shareholders. The owner can be an employee which avoids the self-employment tax. (The company pays it and gets the deduction as a payroll expense.)
Limited liability corporations (LLC’s) were created to allow small businesses to be structured as legal entities with all of the liability protection but the income tax treatment of S Corps.
There are other differences between S Corps and LLC’s as well. There is greater flexibility with the ownership of LLC’s in terms of numbers, citizenship, and other legal entities. For most of us, the differences do not apply.
S Corps are legal companies in the truest sense of the word. There have shareholders, shares, corporate bylaws, annual meetings, and officers. Shares can be sold without restrictions, either to existing or new shareholders.
LLC’s are more like a partnership. There is an operating agreement, member(s) in charge, and percent equity interests. It is more difficult to change ownership and typically there is a dissolution date. Death of a member may be cause for dissolution.
Each state (where you register your business) has different registration (and cost) structures. Also the requirements for various other payroll related costs (such as unemployment insurance, workers comp, and state disability insurance) vary.
There are other considerations. For example, if you rent space and want to purchase the facility, what if you need a financial partner? That would be a separate legal entity, and you can work with passive income for the real estate venture which avoids employment taxes and allows for valid expenses for the operating company.
Can you change? Suppose you operate as a proprietorship and realize you need better liability protection. That is the easiest to do, as you basically morph into the new entity. You can even select a similar name for the entity.
Changing between the others typically involves more work and definitely more expense. In the worst case, you can always allow the one entity to dissolve and start new. But sometimes that is not practical and you need to elect for the changes. In many instances it can be done, and you will need your accounting and/or legal advisers to assist you.
As a sole proprietorship it is easy to change to the new structure. Just prepare the right papers and start anew. Anything else requires the professionals. And there may be significant tax implications. The IRS publishes regulations on these changes.
Granted, this isn’t the most exciting business topic but is one that requires careful consideration so you and your family are legally protected.
Enough No-Doz? You can go back to selling now.
After graduating from the Wharton School at the University of Pennsylvania, Harvey Mackler enjoyed a 20-plus year career in commercial banking, exercising his “golden parachute” in 1996. He was executive vice president and COO of a commercial finance subsidiary in Manhattan and chairman of the Small Business Banking Unit of the American Banker’s Association. He has served on the board of the acclaimed George Street Playhouse in New Jersey and chair of the Easter Seal Society of New Jersey for two years, as well as a captain on his local emergency rescue squad. He acquired GWI Corp in February, 1997 and transformed it to focus on the supplier/distributor/end-user model, growing the company's sales by 500 percent. He is past chair of the SAAGNY Foundation, current Co-Chair of the PPAF EXPO and past Chair of the Supplier Committee of PPAI.