-“Why should I join? I can only do this business as a sole proprietor, right?”
-“Isn’t it complicated and expensive to form a company?”
-“I run my business with my partner, and we have a partnership. Why should we have a company?”
This has to be the most frequently asked question that I–and my own financial and legal advisors–get from our clients. Most people who run small businesses or home businesses are sole owners or partners of mom-and-pop type stores. However, leading authorities on small business estimate that at least 90% of all small business and home business entrepreneurs would benefit from incorporating and using the company as an important component of their overall business structure.
If this is true, why do so many entrepreneurs choose to operate as sole proprietors and general partners? And why you better join?
The answer to the first question is usually (1) ignorance of the tremendous risks of operating in this way or (2) lack of understanding of corporations and other legal entities and the ease with which they can be set up. I should add that if sole proprietorship is dangerous, the partnership is more than twice as bad. This is because a partnership is by default a general partnership, in which each partner is responsible for all the actions of the company, including decisions made by other partners in which he or she does not participate. Now that’s scary!
To answer the second question, we must first define what a corporation is. A corporation is an artificial legal entity that is separate from its owners/shareholders in the eyes of the law. The rich have learned that there are at least three main advantages that make a corporation a
important component of your business structure.
1. Asset Protection.
The single most important benefit of a corporation is the protection it provides for your personal assets.
A corporation is created when you file the appropriate document–the “Budget of Incorporation” in the United States–to the appropriate state legal authority. A corporation cannot be formed through some personal agreement between the parties who choose to form it. It can only come into existence by the country in which it was formed created it, and it has the rights and obligations established by the laws of that country.
Most important here is the idea of a corporate veil–it’s a shield that separates your business assets and activities from your personal and owner/shareholder assets. Because corporations are separate legal entities, if you’re a consultant or translator, for example–or own a small shop–and someone claims they’ve suffered a loss from your business (for example, from a bad translation or an error on your wet floor), and file a lawsuit, only your business assets are at risk. Plaintiffs cannot touch your private residence or car if these are your property and not your company.
There are significant differences between states and the level of protection they provide against corporate veils. In California, for example, there have been several occasions – too many for comfort – where the corporate veil has been breached, thereby allowing financial predators to seize an entrepreneur’s personal assets. This is almost unheard of in Nevada, making it the state of choice for entrepreneurs seeking asset protection.
We will dedicate a separate article to Nevada corporations in depth in a future issue of this eNewsletter. It’s important to note for now that an added advantage of Nevada corporations for many is that Nevada has no state income taxes. If you use a Nevada corporation to conduct business in your home state outside of Nevada (such as California, our home state), you may still be subject to state income tax. Due to the superior asset protection provided by a Nevada corporation, however, it may still be feasible for you to establish a Nevada corporation. A large number of entrepreneurs from other states as well as other states set up Nevada corporations for this reason.
2. S Corporation versus C Corporation: Know Which Is Right for You
The problem of personal service companies arises only with respect to C corporations. Another type of corporation is the S corporation, which, like limited liability companies and limited partnerships, is a passing entity. That is, the corporation itself is not taxed as an entity – rather net income passes through shareholders (such as husband and wife), and is taxed on individual tax returns from shareholders/owners.
There are situations where setting up an S corporation is preferable to using a C Corporation. If you have significant income from a job, for example, and you anticipate significant losses in the early years and you don’t anticipate that your business will generate more than $150,000, S company will be your best choice. However, there are limits to who can be a member of an S corporation, and there are limits to employee benefits at an S corporation.
A sophisticated business structure might use C and S corporations. On the other hand, due to the nature of corporations, you would never want to use either type of corporation to hold real estate. Instead you will 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 company can be used to manage your property stored in another entity.
Or—and it’s a strategy that can be used to run any type of business—the corporation can become part of another business entity. For example, if you want to run a limited partnership, you must have a general partner. But the general partner is responsible for all decisions made and all liabilities that result from them – the general partner, in short, has unlimited liability. So, the smart choice is to use S- or C-corporation to be the general partner. This way you have a general partner with limited liability related to the corporation.
3. Know How to Manage Your Company Properly to Maintain Company Integrity
Regardless of where you set up your company, you need to ensure that you adhere to the appropriate formalities – otherwise your corporate veil can be penetrated very easily, defeating the whole purpose of its founding. Even if you have an accountant who handles books and tax returns, it’s still your responsibility to make sure you’re doing it right.
This involves holding regular meetings and keeping minutes in your notebook, issuing stock certificates, and other formalities.
Personal Service Company
A final problem that may arise, particularly for independent consultants, translators and other professionals, concerns the “Personal Service Corporation”. There are two separate categories of professionals who may be affected by this issue: Those, such as lawyers, accountants, psychologists, and health care professionals, who are required by their state laws to incorporate as professional firms. These companies are automatically classified by the IRS as personal service companies.
In addition, the IRS has expanded the definition of “personal service” to include any work, such as translation or consulting, that is provided personally by the owner/shareholder. This is of particular concern if you are working alone as an individual or as a couple. If 95% or more of your income comes from work in that personal service activity, the company qualifies as a personal service company.
The reason this is of concern is that personal service companies incorporated as C corporations are subject to a flat tax rate of 35 percent and a lower limit ($150,000) on the application of accumulated income tax (typically $250,000). However, these are not insurmountable obstacles to enjoying the benefits of combining:
1. First, another advantage of permanent incorporation makes C corporations preferable to operating using other structures, such as sole proprietorships. This may be of great interest otherwise the high-income spouse may be subject to a higher tax bracket.
2. Second, it is possible to structure your activities so that more than 5% of the activity comes from work that is outside the scope of personal services provided by the owner/shareholder. For example, a translator or consultant may have a branch of business that is involved in network marketing–as a medical professional may own a health food store or other income-generating activity–so the company no longer qualifies as a personal services company.
As you can see, corporations are very valuable tools, tools that the rich use very effectively. If you operate as an independent entrepreneur and don’t use a corporation or popular alternatives to a limited liability company, you are more likely to be handicapping yourself, limiting your profits and paying excessive taxes. With the resources we have today, especially over the internet, there is no reason that the average individual cannot easily start making use of this valuable tool. We currently have 3 entities that we form ourselves and that only costs us the various resources we purchase plus the filing fees required by the State of California and postage to set it up. And we have made sure to get the right form through the sources we listed on our Resources page so that we can maintain the legality of this entity.
“Can’t I just wait and start as a sole proprietor or partner and merge later?” we are often asked.
Of course, if you don’t mind exposing all of your personal assets to risk, paying higher taxes, and finding yourself 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’s no reason why you should.
Even if you decide to allow a tax attorney to help you with the formalities, it’s best to do so with the knowledge you need to assess whether the recommendations he or she makes are actually in your best interest.
At the very least, you’ll know enough to head for the nearest exit if any of the “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