If you’re about to go out on your own and create a business, congratulations. Once you’re here, on the side of the entrepreneurs and others who make the economic engine run, you’ll wonder why you didn’t start sooner. Salaried employment is great for some people, less so for others.
But if you’re going to do it, do it right. There’s more to creating a business than buying a license (you do know you have to buy a license, right?) and creating a website.
Most general contractors, plumbers, electricians, gardeners and graphic designers who set up shop don’t even think about what legal form their new business is going to take. (That’s legal “form” as in “organization or arrangement.” We’re not talking about a piece of paper you have to fill out, at least not directly.)
Making the wrong decision about legal form can cost you serious money even before the first sale. While you might have learned the terms “sole proprietorship” and “corporation” in high school, back when they meant nothing to you, now would be a good time to determine what they do mean and how organizing your business under one or the other can hurt or hinder you.
Don’t Go The Default Route
Unless you specify otherwise, your new business will operate as what’s called a “sole proprietorship” – meaning there’s no practical distinction between you and the business itself. The “advantage” to a sole proprietorship is that it costs nothing to start, aside from the aforementioned business license and related fees. Kind of like how it’s an “advantage” to not have auto insurance, because of all that money you’ll save by not paying a premium.
You don’t want to do business as a sole proprietor. Maybe 150 years ago you did, if you made horseshoes and paid your apprentice under the table. Since there’s no legal difference between you and the business under a sole proprietorship, you’re on the hook for everything. Everything. If a customer sues an employee, whether it’s justified or not, you could be legally responsible for far more money than your company’s worth.
You want to spend a little money before opening and incorporate. Before you hesitate at incurring upfront out-of-pocket expenses, understand that it’s forward thinking like this that separates the successful from the merely busy. And once you incorporate, you’re not just a business owner, you’re a corporate shareholder with all the rights that affords.
To incorporate, you have to spend money filing with a state. Not “your” state”, “a” state. Just because you’re headquartered in New Hampshire, that doesn’t mean you can’t incorporate in Montana.
Ever wonder why the catchphrase “a Delaware limited liability company” found its way into the vernacular? Not “some”, nor “many”, but most American publicly traded corporations are incorporated in The First State.
There’s a good reason for this. Under U.S. law, your corporation operates under the laws of the state in which you’re incorporated. This makes sense, otherwise you could be subject to 50 different sets of state laws, which isn’t exactly efficient. Delaware protects shareholders (you’re a shareholder, remember?) more than other states do. Some states require your corporation to have multiple officers and directors – Delaware lets you get by with just one. You don’t even have to be a citizen. You don’t even have to live in the U.S. You don’t even have to publicly disclose your name.
For a small corporation whose sole shareholder is also its manager, incorporating in Nevada might make more sense. Should a director of a Delaware corporation commit “gross negligence”, that can still lead to personal liability. Maybe that’s morally sound, pending a trial, but from a financial perspective it tilts the scales toward incorporating in Nevada if you want to avoid legal hassles that can derive from baseless accusations.
Wyoming and Alaska are popular states for incorporating, too. On the other hand, incorporating in California or New York sucks on wheels. California’s laws are tilted disproportionately in favor of employees, customers, people who slip and fall on the sidewalk outside your retail location…basically anyone but you. New York’s aren’t much better. (The diaspora of businesses from each of those states is purely coincidental to this, by the way.)
But there’s so much paperwork. Oh, stop it. Yes, paperwork sucks. It’s tiresome, and counterproductive, and exists largely to satisfy the government bureaucrats who make their living by creating byzantine regulations and getting people to adhere to them.
But if you’re sufficiently disposed, paperwork still beats the hell out of working for someone else.
Three Types Of Corporations
In the United States, there are three major types of corporation – the C corporation, the S corporation and the limited liability company (which is technically not a corporation, but close enough for our discussion.) C and S corporations are named after the particular subchapter of Chapter 1 of the Internal Revenue Code.
Most major corporations are C, most smaller firms S. The big difference between the two is that C corporation shareholders are subject to double taxation: the government taxes the company’s income at corporate rates, and taxes the dividends after the corporation distributes them to the shareholders.
Yeah, that’s what you call money when it filters through to the shareholders in a corporation. Dividends in this case serve the same purpose that wages and salaries do for ordinary employees in ordinary jobs.
But if you’re an S corporation, that’s not an issue. Also, you can pay yourself a salary and the government won’t subject it to self-employment tax. S corporations are designed for small companies, which yours will presumably start out as.
Finally, there are LLCs. The most important difference between them and S corporations is how the IRS treats excess profits, or in IRS jargon, “distributions”. If you own and operate an S Corporation and pay yourself a “reasonable” salary out of the profits, the remaining profit is “distributed” to you at the end of the year and isn’t subject to self-employment tax. Not so with an LLC. (But you can tell the IRS you want your LLC to be treated like an S Corporation for tax purposes. Just file Form 2553 before “the 16th day of the 3rd month of the tax year.”)
LLCs require less paperwork than S corporations, but with one big tradeoff: your LLC has to issue you a K-1 statement, which lists your share of the LLC’s income and expenses, to be transferred to your 1040. It’s not that different than paying regular old income taxes.
For a typical one-person S corporation, the paperwork consists of little more than this:
-every month, returning a letter to the state department of taxation. Takes about 30 seconds, costs the price of a stamp.
-every quarter, paying taxes. A lot easier when you save receipts as a matter of course. If you want, hire an accountant.
You’ll almost sound grown up when you run an S corporation: you get to elect a board of directors and everything.
A board of directors? My head is spinning.
You know who your directors and officers are? You, and whomever you want to appoint, assuming you want to appoint someone. In Delaware, remember (and in Nevada), you don’t even have to do that. You do have to hold an annual meeting, though. You can do this in your bedroom, and maybe one day, in your pool. (One point in favor of LLCs is that they don’t have directors’ meetings, or even directors.)
And we haven’t even gotten to the best part: tax writeoffs, which deserve a post of their own. As wonderful as they are, they’re yet another indication of how our tax code, flawed and labyrinthine as it is, exists to punish employees at the expense of business owners. While you might not like the system, the opportunity is there to take advantage of it.
Greg McFarlane is an advertising copywriter who lives in Las Vegas and Lahaina.