– “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 would we need to have a corporation?”
These have to be the most frequently asked questions that I, and my own financial and legal advisers, receive from our clients. The vast majority of people who operate small businesses or home-based businesses are sole proprietors or family business 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 it?
The answer to the first question is usually (1) ignorance of the tremendous risks of operating in this way or (2) unfamiliarity with corporations and other legal entities and the ease with which they can be established. I should add that if sole proprietorship is dangerous, the partnership 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 they did not participate. That is terrifying!
To answer the second question, we must first establish what a corporation is precisely. A corporation is an artificial legal entity that is separate from its owner / 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 your business structure.
1. Protection of assets.
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 come into existence by the state in which it was formed by creating it, and it 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 assets and activities of your company from the private person and the assets of the owner / shareholder (s). Because the corporation is a separate legal entity, if you are a consultant or translator, for example, or you own a small shop, and someone claims that you have suffered damage to your business (for example, from a bad translation or a slip on your wet floor) and file a lawsuit, only your business assets are at risk. The claimant cannot touch his personal residence or his automobile if they are his property and not his 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 a number of occasions, too many for comfort, in which the corporate veil has been pierced, allowing financial predators sixteen of an entrepreneur’s personal assets. This has almost never happened in Nevada, making it the state of choice for entrepreneurs seeking asset protection.
We will dedicate a separate article to the Nevada corporation in depth in a future issue 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 tax. If you use a Nevada corporation to conduct business in your own state of residence outside of Nevada (such as California, our own state of residence), you may still be subject to state income tax. However, due to the superior asset protection that the Nevada corporation offers, it may still be worthwhile to establish a corporation in Nevada. Large numbers of entrepreneurs from other countries and states establish corporations in Nevada for precisely this reason.
2. The S Corporation Versus The C Corporation: Know Which One Is Right For You
The issue 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 transfer entity. That is, the corporation itself is not taxed as an entity; instead, the net income passes to the shareholders (such as a husband and wife) and is taxed on the individual tax returns of the shareholders / owners.
There are situations in which setting up 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 early years and do not anticipate your business making more than $ 150,000, a corporation S 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 the C and S corporations. On the other hand, due to the nature of corporations, you will never want to use any type of corporation to hold real estate. Instead, you will want to use a limited liability company or a 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 held 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 must have a general partner. But the general partner is responsible for all decisions made and for all responsibility derived from them; the general partner, in short, has unlimited liability. Therefore, a smart choice is to use an S or C corporation as a general partner. In this way, you have a general partner with limited liability associated with the corporation.
3. Know how to properly manage your business to keep the corporate veil intact
Regardless of where you establish your corporation, you will need to ensure that you comply with the proper formalities; otherwise, your corporate veil can be pierced very easily, thus defeating the entire purpose of establishing it. Even if you have an accountant who handles your accounting and tax returns, it is still your responsibility to make sure you are doing it correctly.
This involves holding regular meetings and keeping minutes in your registry book, issuing share certificates, and other formalities.
The Personal Services Corporation
A final problem that may arise, particularly for freelance consultants, translators, and other professionals, concerns the “Personal Services Corporation.” There are two separate categories of professionals who can be affected by this problem: Those, such as lawyers, accountants, psychologists, and healthcare professionals, who are required by state laws 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 your earnings come from work 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 fixed tax rate of 35 percent and a lower limit ($ 150,000) for the application of accumulated income tax ( normally $ 250,000). However, this is not an insurmountable obstacle to enjoying the benefits of incorporating:
1. First, the other advantages of incorporating still make C corporation preferable to operating using another structure, such as sole proprietorship. It can be especially attractive if a high-income couple might otherwise 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 is outside the scope of the personal services provided by the owner / shareholder. For example, a translator or consultant might have a branch of business involved in network marketing, like a medical professional might have a health food store or other income-generating activity, so that the corporation is no longer qualified as a corporation. of personal services.
As you can see, the corporation is an extremely valuable tool, one that the wealthy have used extremely effectively. If you are operating as an independent entrepreneur and you are not using a corporation or the popular alternative of limited liability company, chances are you are hurting yourself, limiting your profitability, and paying excessive taxes. With the resources available to us today, especially through the Internet, there is no reason why the average individual cannot easily begin to take advantage of this valuable tool. We currently have 3 entities that we form ourselves that cost us only the cost of the various resources we purchase plus the California state required filing fees and postage to set them up. And we’ve made sure to get the proper forms through the sources we list on our Resources page so that we can maintain the legality of these entities.
“Can’t wait and start as a sole proprietor or partner and join later?” they often ask us.
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 armed with the right information and resources, there is no reason why you should.
Even if you decide to allow a tax attorney to help you with the formalities, it is best to do so armed with the knowledge you need to judge whether the recommendations she makes are in fact in your best interest.
At the very least, you’ll know enough to immediately head to the nearest exit if some “expert” you consult tells you that you “don’t need” to establish a legal entity to run your business.
Copyright 2006 Azur Pacific Associates