SHOULD I INCORPORATE?

So your business is up and running (or on its way!) and suddenly you wonder, what is that incorporation stuff all about anyway?

I too had to ask myself the same question when I started my own law firm. I was surprised at how much inaccurate and confusing information exists on the Internet.  (Yes, even after taking Corporate Law, I still love to Google.  Actually, my triple checking everything is probably a certifiable personality disorder).  

Sadly, over my years of practice in this area, I’ve also found that even professional advisors often give misleading and unclear advice on the topic.

When deciding which entity to select for your business, your decision will be based primarily on flexibility in the ownership structure, limited liability protection, and tax reasons.  Your decision will be between a Sole Proprietorship (“SP”),  Partnership (“P”), Corporation (“C”) or Limited Liability Company (“LLC”) so those are the entities we will focus on. 

What is a Sole Proprietorship?

When you were a child, you may have had a lemonade stand where you peeled and juiced lemons, posted signs around the neighborhood, and took in revenue. That type of business is called a Sole Proprietorship.  It is easy to set up and in many places you are not required to do anything in terms of registration with the government, though I often recommend getting a tax ID for bank account purposes and to look more legit.  You might also need to fill out some registration forms with your State or local Government office, and pay a fee, and, depending on the name you choose, register a fictitious name.  All in all a very simple set up.

Tip: When you file your taxes, you will simply list the name of the business on your tax return and itemize all of your revenues and expenses on a schedule in your personal return. 

So if it is so simple, why doesn’t everybody pick this business form?  The key reason is that it does not protect the owner’s personal property if someone decides to sue your business.  The legal terminology for this is that a Sole Proprietorship does not have “limited liability” protection.  Instead, the business and the individual are considered the same person and if the business is sued or incurs debts, you, the business owner, will be personally liable.  As you can imagine this can be a scary proposition as the end result of a bad business decision could be the loss of a home, car, or personal belongings.  You should also note that even though you may face a low risk of being sued, this risk jumps significantly if you deal with vendors, hire employees or have clients visit your premises.  Even playing a song on your podcast can result in a law suit without paying proper copyright fees.  Due to the additional risk, many people choose to set up a limited liability entity (a Corporation or LLC) instead.  

What about a Partnership?

If there are more than one of you, and the structure of a Sole Proprietorship appeals to you, then what you are looking at is a partnership.  In this case, I highly recommend entering into a formal agreement with your partner.  Good fences make good neighbors and a clear deal helps everyone. 

What if I’m a Licensed Professional like a lawyer?

Unfortunately, regular limited liability entities do not protect against malpractice.   This is one of the few very annoying things about being a lawyer!  Licensed professionals may not just set up a “regular” LLC or Corporation. Instead, they must set up a Professional Corporation or a Professional LLC.  The set up is the same as a regular LLC or Corporation except that you must show the Government your professional license and you still need malpractice insurance.  The idea here is that the Government does not want professionals setting up a limited liability entity and then shirking their professional responsibilities.  I know it is hard to believe that us professionals would ever do something so tricky when everyone knows that we live to help our clients, but those silly legislators tend to get paranoid.  

Now let us take a look at the limited liability entities.

 What about a Corporation?

Corporations were formed in order to better separate personal & business finances (and for a number of other reasons too complicated to get into now but, if you want to know check out my humorous historical account of corporations), and offer a business owner limited liability protection.  As such, generally speaking, a business owner and the Corporation are two completely different people and you will only stand to lose what is invested in the business.  Accordingly, if someone sues the business they can only reach the assets in the business and not your personal assets.   The same concept applies to debts, but as a practical matter, if you have a new Corporation a bank or other lender will probably ask for a personal guarantee as they are fully aware that a Corporation has limited liability.  

Tip: You should remember to include the name of the business on any legal documents such as a loan document or lease, to avoid exposing yourself to liability even with the limited liability protection.

This limited liability protection gives a business owner peace of mind, but there are issues associated with a Corporation.  

1. The first is that in order to form a Corporation you must adhere to a certain amount of formality which requires time and expense.  For example, you must appoint a board (this can be you) and also hold board meetings, develop bylaws and develop minutes.  You must also fund the corporation and issue stock to yourself.  Actually, I think many people quite enjoy holding formal meetings with the CEO, the board, and the stockholder when all three of those positions are the same person.  If I were to incorporate, I’d buy three distinct hats for the momentous occasions.
2. The second is the issue of double taxation.  As a corporation is a separate entity, the government will tax the Corporation and then tax the business owner again on their personal tax return.  This also means that you must file a Corporate tax return.  Double taxation sounds bad, but if you run the numbers with your accountant you may find that it results in less total taxes on an annual basis (but possibly more taxes when you eventually sell your business).

Now, let’s take a closer look at the LLC

The LLC is a relatively new creation and a very common business entity form for new businesses.  It was established to offer the business owner limited liability protection while addressing both of the problems outlined above regarding a Corporation above.  

1. To address the problem of the formality associated with setting up a Corporation, an LLC has the advantage that the business owner is simply not required to adhere to strict Corporate formality.  Instead, a flexible operating agreement is drawn up to describe how the LLC will operate.  
2. An LLC also addresses the problem of double taxation as an LLC is a “pass through entity.” This means that all of the earnings in the LLC are taxed as if you earned them personally.  As such, the entity itself is not taxed but rather the earning “pass through” to you.  The tax preparation is much simpler than a Corporate tax return and is very similar to how you would file as a Sole Proprietorship.

In terms of set up, the process is simple in that you submit forms to the local government, pick a name, pay a fee, and you will have to draw up an operating agreement.

Regrettably, there are two downsides to a LLC.  

1. First, many States have what is called a publication requirement where you must publish in local newspapers that you plan to open a LLC. In some locations, this can be very expensive. For example, in Manhattan, this requirement can cost over a thousand dollars.  
2. The second disadvantage is that a LLC is subject to self-employment taxes on all of the income earned.  There is relief on the employment taxes though as the LLC can elect “S status” to eliminate this requirement on at least a portion of the employment taxes.  This is further described below.

Tip: If your location requires publishing, you should consult a local lawyer and ask about the impact of not meeting the publication requirement as it may not be as bad as you think.  

What is this I hear about S-Corps or S-Status?

When you search the Internet, you will see many references to an “entity” referred to as a S-Corporations and you will often see self-employment taxes as one of the advantages of a S-Corporation over a LLC.  You should get all of that out of your mind and think of S as a TAX STATUS rather than as a type of entity.  If you do, most of your confusion will vanish. So here is the lowdown.

BOTH a Corporation and a LLC may elect S status and if they do, they will avoid self-employment taxes on at least a portion of their earnings.  

Tip: In order to be eligible, you must file the S tax status election with the IRS right after you set up the LLC or Corporation (they give you around 60 days).

I’ll try to make this clear with an example: An entity (LLC or Corporation) makes $100,000 and the owner assigns themselves a salary of $60,000 (salary must be reasonable in order to qualify).  When this occurs, and S status is elected, the owner will only have to pay self-employment tax on the $60,000 rather than the full $100,000.  However, you need to know that there are serious pitfalls for people who are using this strategy to avoid self-employment taxes on income gained from personal services, talk to your advisor and, just a tip, don’t lie to the IRS.

An S status works and it may seem like the perfect middle ground.  Regrettably though, it too has its drawbacks as the ownership structure has certain requirements and you must be a U.S. resident for tax purposes to be eligible.  In addition, if you elect S Status there is a limitation on the amount of owners that may hold shares or membership units in the company.  If you are considering electing S Status, you should consult a Lawyer or Accountant as it is a complicated area.

Do I Need A Lawyer To Set Up My Business And Guide Me?

Yes and in most cases an Accountant too.  While you do not have to hire a lawyer to set up a business, the choice of business form has significant tax, financial and liability implications that you should carefully consider so that you set up your business the right way.  Plus, and now you know, they can’t hide behind limited liability if they give you bad advice.