“Why should I join? I can do this business as a sole proprietor, right?”
– “Isn’t it complicated and expensive to form a corporation?”
-“I run my business with my spouse, and we have a partnership. Why do we need to have a corporation?”
These have to be the most frequently asked questions that I, and my own financial and legal advisors, get from our clients. The vast majority of people who operate small businesses or home-based businesses are sole proprietors or mom-and-pop store-type partners. However, leading small business authorities estimate that at least 90% of all small business and home business entrepreneurs would benefit from incorporating and using a corporation as an essential component of their overall business structure.
If this is true, why do so many entrepreneurs choose to operate as sole proprietors and general partners anyway? And why would it be better to incorporate?
The answer to the first question is usually (1) ignorance of the tremendous risks of operating in this way or (2) lack of familiarity with corporations and other legal entities and the ease with which they can be established. I should add that if sole proprietorship is dangerous, society is more than twice as bad. This is because the partnership is by default a general partnership, in which each partner is responsible for all actions of the company, including decisions made by the other partner in which she did not participate. That’s terrifying!
To answer the second question, we must first establish what precisely a corporation is. A corporation is an artificial legal entity that is separate from its owners/shareholders in the eyes of the law. The wealthy have learned that there are at least three main advantages that make the corporation a
essential component of its business structure.
1. Asset protection.
The most important benefit of the corporation is the protection it provides to your personal assets.
The corporation is created when you file the appropriate documents, “Articles of Incorporation” in the United States, with the appropriate state legal authorities. A corporation cannot be formed by some private agreement between the parties who choose to form it. It can only be born by the state in which it is created, and has the rights and obligations established by the laws of that state.
Most important here is the notion of the corporate veil: this is the shield that separates the business assets and activities of the private person and the assets of the owner/shareholder. Because the corporation is a separate legal entity, if you are a consultant or translator, for example, or own a small shop, and someone claims that they have been harmed by your business (for example, because of a poor translation or a slip). on your wet floor) and file a lawsuit, only your business assets are at risk. The claimant may not touch her personal residence or her car if it is owned by her and not by her corporation.
There are significant differences between individual states and the degree of protection they provide to the corporate veil. In California, for example, there are several times (too many to be comfortable) where the corporate veil has been lifted, allowing financial predators to seize an entrepreneur’s personal assets. This almost never happens in Nevada, making it the state of choice for entrepreneurs seeking asset protection.
We will devote a separate article to the Nevada corporation in depth in a future edition of this e-newsletter. It is important to note for now that an additional advantage of the Nevada corporation for many is that Nevada has no state income taxes. If you use a Nevada corporation to conduct business in your own home state outside of Nevada (such as California, our own home state), you may still be subject to state income tax. However, due to the superior asset protection provided by the Nevada corporation, it may still be worth establishing a Nevada corporation. A large number of entrepreneurs from other countries, as well as from other states, establish corporations in Nevada for precisely this reason.
2. S Corporation vs. C Corporation: Know Which Is Right For You
The subject of the personal services corporation only comes up with respect to the C corporation. The other type of corporation is an S corporation, which, like the limited liability company and limited partnership, is a pass-through entity. That is, the corporation itself is not subject to tax as an entity; instead, the net income passes to the shareholders (as husband and wife) and is taxable on the shareholders/owners’ individual tax returns.
There are situations where establishing an S corporation would be preferable to using a C corporation. If you have significant income from a job, for example, and anticipate significant losses in the first few years and don’t anticipate your business making more than $150,000, an S corporation It will be your best choice. However, there are limitations on who can be members of an S corporation, and there are limits on employee benefits in an S corporation.
A sophisticated business structure will likely make use of both C and S corporations. On the other hand, due to the nature of corporations, you will never want to use either type of corporation to own real estate. Instead, you’ll want to use a limited liability company or limited partnership. However, if you are a real estate investor, there may still be room for an S or C Corporation in your overall business structure. For example, a corporation could be used to manage its properties in another entity.
Or, and this is a strategy that could be used to conduct various types of business, the corporation could be part of another business entity. For example, if you want to operate a limited partnership, you will need to have a general partner. But the general partner is responsible for all decisions made and all liability resulting from them; In short, the general partner has unlimited liability. Therefore, a smart choice is to use an S or C corporation to be the general partner. In this way, you have a general partner with the limited liability associated with the corporation.
3. Know how to run your corporation properly to keep the corporate veil intact
Regardless of where you establish your corporation, you will need to ensure that you observe the appropriate formalities; otherwise, its corporate veil can be pierced very easily, thus defeating the whole purpose of establishing it. Even if you have an accountant handling your bookkeeping and tax returns, it’s still your responsibility to make sure you’re doing it correctly.
This involves holding regular meetings and keeping minutes in your log book, issuing share certificates and other formalities.
The Personal Services Corporation
A final issue that may come up, particularly for freelance consultants, translators, and other professionals, concerns the “Personal Services Corporation.” There are two separate categories of professionals that may be affected by this issue: Those, such as attorneys, accountants, psychologists, and health professionals, who are required by state law to incorporate as professional corporations. These corporations are automatically classified by the IRS as personal service corporations.
Additionally, the IRS has expanded the definition of “personal service” to include any work, such as translation or consulting, that is performed personally by the owner/shareholder. This is of particular concern if you are trading on your own as an individual or as a couple. If 95% or more of its earnings come from working in that personal service activity, the corporation qualifies as a personal service corporation.
The reason this is concerning is that a personal services corporation incorporated as a C corporation is subject to a flat 35 percent tax rate and a lower cap ($150,000) for the application of retained earnings tax (usually $250,000). However, this is not an insurmountable obstacle to enjoy the benefits of incorporating:
1. First of all, the other advantages of incorporating still make the C corporation preferable to operating using another structure, such as sole proprietorship. It can be especially attractive if an otherwise high-earning couple might be subject to a higher tax bracket.
2. Second, it is possible to structure your activities so that more than 5% of the activity is derived from work that falls outside the scope of personal services provided by the owner/shareholder. For example, a translator or consultant may have an arm of the business involved in network marketing, such as a medical professional may have a health food store or other income-generating activity, for which the corporation no longer qualifies as a corporation. Personal services. .
As you can see, the corporation is an extremely valuable tool, one that has been used extremely effectively by the wealthy. If you are operating as an independent business owner and not using a corporation or the popular limited liability company alternative, chances are you are doing yourself a disservice, limiting your profitability and paying excessive taxes. With the resources available to us today, especially through the Internet, there is no reason the average individual can’t easily start taking advantage of this valuable tool. We currently have 3 entities that we form ourselves that cost us only the cost of the various resources that we purchase plus the State of California required filing fees and postage to set them up. And we have made sure to obtain the proper forms through the sources we list on our Resources page so that we can maintain the legality of these entities.
“Can’t I just wait and start as a sole proprietor or partner and join later?” we are often asked.
Certainly if you don’t mind exposing all of your personal assets to risk, paying higher taxes, and being more likely to be subject to an IRS audit. Some people prefer to do things the hard way, but with the right information and resources, there’s no reason you should.
Even if you decide to let a tax attorney help you with the paperwork, it’s best to do so armed with the knowledge you need to judge whether the recommendations they make are in fact in your best interest.
At the very least, you’ll know enough to immediately head to the nearest exit if any “experts” you consult tell you that you “don’t need” to set up a legal entity to run your business.
Copyright 2006 Azur Pacific Associates