Should I Incorporate My Business
Should I Incorporate My Business?
The best answer for that question is maybe…but not right now. If you have an interest in forming a new business, don’t rush out to the nearest law firm and spend a lot of money to form a corporation or an LLC. The best advice that I have is to operate it as a self-employed individual for the first year, and maybe even a couple of years,
You need to “get your feet wet” as the old saying goes, and see if your idea is going to pan out. If it doesn’t, you’ll know soon enough, and can walk away from it without having spent a lot of money. That being said, there are basically three types of business organizations.
The first is the simplest to form, and that is a sole proprietorship. This is also known as freelancing or self-employed individuals. It generally consists of one owner who operates under maybe a trade name. Most states don’t require registration on this type, but check with your own state’s rules. You may be required to register the trade name.
The second type of business organization is a corporation. The owners of a corporation are its stockholders, and some states may require that you have an attorney set it up. Profits or losses for a corporation are paid/handled at the corporation level. Stockholders may be paid as officer wages on a form W-2, or dividends. More on the Sub S later.
The third type of organization is the partnership. Two or more individuals are required to operate as the partnership and are taxed personally on the entity’s profits. There are many more factors involved in operating as a partnership and will be covered further in this article.
What you need to consider when you select your type of organization
- The first is the ease of startup and the cost. Is registration required?
- How is the business controlled and how do the owners get money out of the business?
- How is the business taxed? Does the owner have to pay?
- Who is liable for any debt? Can liability be limited in any way?
What does my state require for each type of organization?
Although many states have similar requirements for the basic setup, you need to check with your state. There may be rules and regulations that you must follow in order to setup a specific type of organization. It may be a variation of one of the three basic business types and if your state doesn’t permit that, you need to know it before you proceed.
Usually on the state’s web site, there is a section that may explain this factor. If not, call them until you get the information that you need.
Operating as a sole-proprietorship
This is obviously the easiest one to setup. Get a trade name if you want one, and setup your books and records. This type of organization is operated by one individual and is not a separate entity from the owner. This means the owner pays the taxes, usually on a Schedule C on his personal tax return.
The owner is also liable for any debts or other liability of the business. Be sure to get a separate business checking account, and other records to track all income and expenses for the business. This will be used to prepare the Schedule C form. The owner cannot pay himself W-2 wages, but other employees must be paid that way.
Operating as a corporation
When you setup a corporation, it’s considered as a separate business entity, both from personal liability and taxes. In most states, there is no requirement that you have an attorney prepare the documents and various filings that are needed. If you’re not comfortable in preparing the documents, by all means, use an attorney.
Corporations pay their own income taxes at the corporate level at a flat rate of 21%. This rate went into effect with the Tax Cuts and Jobs Act (TCJA), effective January 1, 2018, and will expire December 31, 2025. However, we now have a new administration, and some of the proposals being considered are an increase in the corporate tax rates. Be advised however, that any dividends paid by the corporation to the shareholders, are taxed to the shareholder.
The C Corporation setup may be advantageous to some businesses, such as mine. Before you make any decision to incorporate, meet with a financial professional if you don’t have the expertise in taxation.
Operating as a Sub-chapter S corporation (S-Corp)
Using this type of organization is beneficial for many small business owners. You have the benefit of liability protection as a corporation, and income or losses are passed through to the stockholder to report on their personal tax returns, at their personal tax rates.
To use this type of setup, you first have to form a corporation with your state. When that is done, you then complete IRS Form 2553, and submit it to the IRS, formally electing to be taxed as an S Corp. This part can be a little tricky for some, so be sure to get professional help if needed. The IRS will send you a letter approving your election in a few months unless the lack of staff due to Covid-19 continues.
Operating as a Limited Liability Company (LLC)
Most, if not all states, permit the formation of an LLC. The Articles of Organization, among other documents, are filed with the state. Even though the LLC isn’t a corporation, it does afford some liability protection for the owner as well as other benefits.
You’re allowed to have only one member, but if you do, you report the activity on your personal tax return, on a Schedule C and if a rental, on Schedule E. If you have more than one member, then you’ll be filing a Form 1065, a partnership tax return.
With a partnership, the income and/or losses are passed through to the individuals, who report the activity on their personal tax returns. There are a few variations on the formation that will allow you to be taxed as a corporation.
Operating as a Single member LLC
This type of operation is unusual, but many individuals do operate this way. The owner gets the benefits of liability protection as an LLC, but does not file a partnership tax return. Instead, he reports all of the activity on a Schedule C on the personal return, or if the entity is a rental, on Schedule E.
The IRS considers a single member LLC (SMLLC) as a disregarded entity for tax purposes. What this means is the business is considered to be separate from the owner for purposes of taxes only. When taxes are filed, they are reported as a sole proprietor, and income taxes as well as self-employment taxes are paid by the member.
There are no special filings with the state of formation. You register as an LLC, file Articles of Organization and Operating Agreement like any other LLC. If you so desire, you can choose to be taxed like a corporation too.
Operating as a partnership
When you elect to setup a partnership, you will have two or more individuals who desire to share the benefits and risks of the business. It can also be setup to have two types of partners. The general partner is liable for the debts and other actions the partnership may enter into.
Limited partners usually are investors who have no say in the day to day operations, nor do they share any liability beyond the amount of their investment. Some states will permit the formation a general partnership, a limited partnership, and also a limited liability partnership.
Another type is a joint venture that can operate as a partnership between two businesses with the intent to function for a definite purpose.
Operating as a professional corporation
This type of organization is usually used by those professions who provide a professional service such as physicians, accountants, architects, and law firms. Even though the firm may operate as a corporation, each professional is liable for any of their own wrongful actions.
Operating as a limited partnership
Usually when a partnership operates under this formation, it has general partners and limited partners, and is created as an entity distinct from its partners. The general partners do have the responsibility and liability to handle the day to day operations and are liable for all debts and actions of the other partners.
The limited partners have no liability for any debts or actions of the other partners, nor do they take part in any of the operations of the business.
Operating as a limited liability partnership (LLP)
This type of organization is as its name states, limited liability for all. General partners are the only type of partner, and they don’t have any liability for actions of the other partners or its employees.
Is an attorney required to start my business?
Most of the states don’t have a requirement that an attorney prepare and file the organizing documents. They even give the organizer instructions on how to file everything online. If you’re a single owner filing the online documents, it might be an easy & low-cost way to start your business.
However, if you have another individual who has ownership in the business, you’ll want to protect yourself. Documents like the operating agreement, partnership agreement, by-laws, and others must be drawn exactly the way that you and the other owner desire. In this scenario, I would highly recommend that you engage the services of a competent, and experienced attorney that does this type of work.