And you thought my business plan instruction article was boring! Take out a double shot of No-Doz!
(Note – In addition to the businesses in our industry, this also applies to all of the independent contractors. You need a legal structure. Absent one, you are 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 you should consult an expert for detailed advice and state registration requirements.
The easiest is the sole proprietorship. You own the business. 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.)
ANY LIABILITIES INCURRED BY THE PROPRIETORSHIP ARE PERSONAL. THAT MEANS IF SOMEONE IS OWED MONEY, THEY CAN GET A JUDGMENT AGAINST YOU PERSONALLY. THIS ALSO INCLUDES PRODUCT LIABILITY. 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.)
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 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 are 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 may involve more work and definitely more expense. In the worst case, you can always allow 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.
You can go back to selling now.
A 1975 graduate of the Wharton School at the University of Pennsylvania, Harvey enjoyed a 20+ year career in commercial banking, exercising his “golden parachute” in 1996. In his volunteer life, he is a past chair of the Small Business Banking Unit of the American Bankers Association, Easter Seal Society of New Jersey, the SAAGNY Foundation, PPAF EXPO, and Supplier Committee of PPAI. He is also a past President of PPAF. PPAI awarded him the H. Ted Olson Humanitarian Award in 2013.