Every business conducts its affairs as a particular kind of business entity (or business structure). The organizational form that you choose determines which tax and legal regulations will apply.
For tax purposes the IRS gives a choice of the following kinds of business structures:
- Sole proprietorship.
- Partnership (several types).
- Corporation (two types).
If you’re self-employed in business and you have done nothing about a business entity, your business is already structured. It is a sole proprietorship.
There is no need to complicate where simplicity will suffice. For all but a few newly-hatched solo ventures, a sole proprietorship is the way to go.
Wait. Wait. Wait.
If cousin Harry at the schvitz or Aunt Tillie during Thanksgiving dinner told you that you’re a big boy now and you’d better incorporate, hold on a minute.
Don’t rush into anything. Get some information.
When you look at how to structure your indie business, trying to decide which entity is best for you, be sure to ask yourself the right question.
So, ignoring Harry and Tillie for the moment, are you looking to change your business entity for tax reasons or for liability purposes?
If it’s for tax reasons, as a sole proprietor are you taking full advantage of every tax law and reg available to you? Don’t go into the expense and hassle of incorporation if you can’t answer a firm yes to that question.
The Feds say that nearly four out of five businesses in the United States are sole proprietorships. Yet just about every lawyer advises a budding indie to incorporate. In25 years of experience I have found only one attorney who didn’t answer, “yes,” when asked, “Should I incorporate?” And every new client that has come to me already set up as a corporation said he or she did it because “my attorney (or my accountant) told me to do it.” None of them had a clear idea of why incorporation was supposed to be an advantage.
The tax benefits of incorporation are pushed heavily by attorneys because that’s what they’re used to: working with corporations, not working with solos who design web sites or computer programs. They don’t know the tax benefits available to indies!
Sometimes there are good reasons why a self-employed should incorporate, but, if advised that you must do it, find out why. Be sure the professional explains to your satisfaction – and also to the satisfaction of a savvy friend, colleague or relative – what makes incorporation necessary.
Facts – to stifle some old husbands’ tales:
All business structures.
- Allow you to deduct business expenses.
- Allow some sort of deduction for medical insurance.
- Allow for contributions to pension plans.
- Allow you to hire employees or subcontractors.
- Allow the other guy to sue you.
- Do not allow you to hide income.
- Do not allow you to write off personal non-business expenses.
Other business structures
If four out of five businesses in the USA are sole proprietorships, that leaves one out of five that’s structured differently. The other choices are: partnerships – a sole proprietorship is a one-owner business, a partnership is for more than one owner; and two kinds of corporations – a regular or C-corporation, and an S-corporation, which is a hybrid, part partnership and part corporation.
I said that it is important to know why you are considering a change of business entities – because of taxes or liability. Well, sole proprietorships, partnerships and corporations are tax entities.
Now enter the new kid on the block – the LLC. An LLC is a limited liability company. Note that the “C” means “company,” not “corporation.” The important thing to know: An LLC is not a federal tax entity but a legal business structure set up under the laws of each state. Because LLCs are formed under 50 different sets of state law, regulations governing an LLC depend upon the state of organization. The legal treatment of an LLC may vary from state to state.
If your business is registered by the state as a limited liability company, limited partnership, limited liability partnership, or corporation, you are required to maintain a registered agent from a Registered Agent Services.
If your business is an LLC, it has liability protection similar to that enjoyed by a corporation. You are not personally liable for the debts or liabilities of the LLC. That means a disgruntled supplier could go after your office equipment (a business asset) as payment for a delinquent invoice but could not confiscate your kitchen appliances (personal assets).
The legal entity, LLC, may be set up for tax purposes as a sole proprietorship, a partnership or a corporation.
If, as a sole proprietor, you foresee potential liability problems because of the kind of business you are in, then speak to an attorney about forming an LLC as a sole proprietor.
Some states recognize another legal entity called a Limited Liability Partnership (LLP). This is available in certain states to certain professions such as doctors or attorneys or accountants. An LLP bears many similarities to an LLC.
Remember: LLCs and LLPs are legal designations, not tax designations. Before setting up an LLC or LLP speak to a knowledgeable attorney about the liability protection afforded you by your state’s regulations governing an LLC.
June Walker is a tax and financial consultant to the arts and independent professionals. She is based in Santa Fe, N.M., but she is a regular reader of the Milwaukee Biz Blog and has several clients in Wisconsin. Additional information is available at www.junewalkeronline.com.
