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Article added or updated:
04/29/2008 |
Thinking about starting your own business? Do
you need the protection of a corporation?
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See Also:
S Corp, LLC, C Corp
LLC vs. Corp
S Corp-LLC Compared
Corporation vs.LLC
S Corp vs. LLC
S Corp vs LLC 2
Business EntitiesYou
don't need to incorporate to work on your own, but you do need
protection.
After he was laid off in April
from a videogame company, Jeffrey Goodsill of Concord, Mass.
decided to start his own. His lawyer advised him not to waste money
incorporating until he had a business plan and started to negotiate
financing. In September Goodsill, 41, joined as a shareholder in a
five-person gaming startup that had just set up as an S Coprporation .
"I'm glad I waited. Incorporating would have been an unnecessary
headache," he says.
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You don't need to form a corporation to start
out on your own. Almost 18 million Americans do business as
unincorporated "sole proprietors" and report their revenue and expenses
on Schedule C of their personal income tax returns. But sometimes there
are good legal, tax or business reasons to form one of the entities
available today from the corporate alphabet soup. They include
traditional Subchapter C corporations, which pay corporate income taxes,
and so-called passthroughs, which don't. The latter category includes
Sub-chapter S Coporation , limited partnerships (L.P.s) and the newer
limited liability companies (LLC s). Since a passthrough doesn't pay
federal income taxes of its own, its taxable income is passed through to
the tax returns of its owners, who then have to declare it whether or
not the profits are distributed as cash.
Forming a no-frills LLC , L.P. or S Corp costs
$750 to $1,500 in lawyer and filing fees, depending on the state. You
can do it yourself on the cheap with canned documents available on the
Internet. But, particularly if you're planning on taking on partners or
investors, you'll need help in deciding which entity suits you best and
in making sure the documents protect your interests. Some points to
consider:
LEGAL RISK
As a sole proprietor you are personally
responsible for all of a business' liabilities, including its debts and
any liability judgments against it. But buying insurance can provide
adequate liability protection and a corporate or partnership shield
alone might not get you off the hook for negligence, says Buffalo lawyer
Scott Friedman. You probably already have car and homeowner's insurance
and an umbrella policy for $1 million or more that kicks in after your
normal auto and homeowner's limits are exhausted. Good news: Your car
insurance normally covers some business use of your car. Bad news: Your
homeowner's policy offers little protection for business use of your
home.
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If you are unincorporated and
work from home, but don't have many business visitors, you may be able
to get by with a business endorsement on your homeowner's policy. For
$40 to $200 a year, it should cover $5,000 to $10,000 in office
equipment from theft and should protect you on the liability side if the
FedEx man slips and sues. (But plans vary, so check with your agent and
read the fine print.) If you hold regular business meetings at your
home, or if you're incorporated and your policy doesn't allow
endorsements for corporations, you'll probably need a separate business
policy, at a cost of $300 to $400 a year. Some types of home-based
businesses always need separate coverage, e.g., photography
studios, day care providers.
Whether incorporated or not, if you're an
architect, engineer or one of dozens of other professionals, you really
should buy errors and omissions insurance. For an architect, $1 million
in coverage (a common amount sold) starts at $1,500 a year.
Think you're not at risk? Try thinking as
creatively as the plaintiffs' bar. Barry and Jennifer Gribbon, of
Los Angeles, formed Homerun Entertainment after he was laid off
last year as a vice president of Scripps Productions. They produce
Food Finds for the Food Network and carry $1 million in E&O
insurance per project. Muses Barry: "We have no way to guarantee that
guests on the show are telling the truth. If some chef says to add a
given amount of salt and it turns out to be a lethal dose for someone
watching the show, I'm covered if the network gets sued and says it's
our fault."
Note that while a limited partnership or a
limited liability company theoretically limits personal liability for
those who form it, there's less protection if you perform day-to-day
operations or make decisions for the business. So get insurance. An
entity should, however, shield you and your investors from normal
business debts should your business go bankrupt--unless you personally
guaranteed them.
If you own multiple pieces of real estate, keep
each in a separate LLC , advises Andrew J. Sherman, a Washington, D.C.
lawyer and author of The Complete Guide to Running and Growing Your
Business. That way, he says, if something falls on a kid's head in a
store you have leased to a toy retailer, your other properties won't be
at risk.
TAXING MATTERS
C corporations have a big tax disadvantage:
Their profits are taxed at the corporate level and again if and when
they are distributed. Yet a C can still make tax sense if its profits
are likely to be modest and you want to retain profits in the business.
A corporation's first $50,000 in annual profit is tax free and the next
$25,000 is taxed at just a 15% rate. But: If yours is a "personal
service corporation"--meaning the corporation's main output is your own
work effort, for instance as consultant or pet groomer--then all your
profits are taxed at a flat 35% corporate rate and you'll usually do
better with a passthrough. State taxes might influence which passthrough
you use. California levies an $800 a year minimum tax on all LLC s, C and
S corporations, regardless of their profitability, but not on L.P.s.
Another issue is payroll taxes. The
self-employed pay a 12.4% Social Security tax on the first $84,900 of
earnings for 2002 ($87,000 for 2003) and a 2.9% Medicare tax on all
earnings. (Note: If you have paid the Social Security maximum at a day
job, you don't have to pay it again on your self-employment income.)
Caution: While LLC s are popular these days, it
is unclear under current law whether owners are liable for the
self-employment tax on all their earnings, or on just the salary they
take out. You can avoid this problem in two ways. One is to create an S Corp subsidiary under the LLC . Say you have a medical practice and own
the building housing your office. Stick the building in the S
corporation and pay it rent. The net earnings of the subsidiary are
profits and not salary and won't get hit with the extra 2.9% tax. The
other solution is to elect to have your LLC taxed as an S corp, which is
allowed under the IRS' "check the box" rules, although that solution can
create its own complications.
Regardless, if you have capital invested in
your business, you'll need some sort of entity to avoid being unfairly
nicked for that 2.9% Medicare tax on every penny you earn. After all,
some of what you earn is return on investment. Daniel Marshall, 30, who
started Blue Ideas, an Indianapolis accessories maker for handheld PCs,
in 2001, has poured $20,000 in savings and $40,000 in borrowed money
into the business. He figures his S Corp saves him about $2,000 a year
in taxes, even after the extra accounting costs are figured in. Just
don't be greedy. Pay yourself a reasonable salary, as Marshall does.
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As always, please check with your tax professional,
CPA or lawyer
prior to acting on any advice found here. We do NOT dispense advice on
any articles contained here.
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