Small business owners frequently ask me, “Should I incorporate? If yes, which business entity is right for me?” The answer depends on several questions a business owner should ask herself.
The first question I usually ask the person is “What have you got to lose?”
If you have a home with equity in it, retirement accounts and/or other large assets, you may want to incorporate, or set up an LLC, or some form of limited partnership to keep your personal assets separate from your business assets, in case your business gets sued. Or you go through a nasty divorce, and your ex-spouse wants part of your business, or worse, wants to drive you out of business.
On the other hand, if you have no assets that anyone can touch, you may not want to go to the expense of setting up a corporation, limited partnership or LLC and keeping up the corporate, partnership or LLC formalities.
The next question I ask is, “Have you spoken with your financial advisor?” Often times she will advise you one way or another, depending on your income from different sources.
This first of five articles will assume you are considering setting up some type of business entity. Each of the five articles will give you two good reasons why you may want to take the plunge. So stay tuned.
- Tax Issues. Depending on whether or not you have income-producing assets outside of your business, tax considerations can be a powerful determining factor in the type of business you set up. The individual tax rate that a sole proprietor or partner in a general partnership will pay, may be worse than the corporate tax rate, if you are in a high income bracket. And it may change over time. One of my clients, who had been an LLC for many years, recently came to me and said that their CPA informed them that if they been an S corporation for the previous tax year, they would have saved themselves $17,000 in taxes. They immediately asked me to change their business type to an S corporation, which I did.
Sometimes there are tax differences even between the same type of entity. For example, a C corporation files a corporate tax return (form 1120) separate from its owners’ individual tax return (form 1040). It pays taxes on salaries and dividends paid to the employees, (usually the owners) as well as on its net income, which is also known as “double taxation”. An S corporation, which is run basically the same way as a C corporation, allows its net income to be included on an individual’s tax return (form 1040) as Schedule C income, which is then taxed at the individual’s tax rate, often way lower than a corporate tax rate. No additional tax return is needed.
- Personal Liability Issues. If you have a general partnership or a sole proprietorship, you personally are perceived as the business, without separation. If someone sues your business, they are essentially suing you personally, and can reach in and touch your personal assets (called “piercing the corporate veil) unless you have protected them in some manner. Some asset protection examples might be holding real estate and liquid assets in a trust, or real estate in an LLC. Keeping personal assets safe from business liabilities is the number one reason clients tell me they want to incorporate.
When you have an LLC, corporation or limited liability partnership, and your business is sued, usually the limit to your liability is the amount you have invested in the business, but usually your personal assets are protected. But the simple act of setting up an LLC or a corporation or limited liability partnership is just the beginning of what a business owner needs to do. You must keep up corporate/LLC/partnership formalities, such as documenting meetings, large expenditures of money, changes in direction of the company, keeping business and personal assets separate, and much more. If you fail to do this, and many owners do, you may lose your liability protection, because the court will find you are not operating like a true business but rather only an extension of the owner.
Our next article discusses two more good reasons to set up a business entity.
Thinking of setting up a business entity? Call Nancy at 415-399-0993 to determine which business type is right for you. There is no charge for the consultation. Mention this article and get a free copy of Nancy’s “10 Commandments for Small Business Success.”