When you incorporate a business, it’s like you have created a person out of thin air. That business is considered a separate legal entity from the shareholders who own the business. In the case of a small business, it’s usually one or two business partners. In the eyes of the government, a business is separated from the owners who run that business. This is different from a sole proprietorship, where you and the business are one and the same. There is no legal separation in a sole proprietorship.
It is not only legally separate, but also taxed separate. At the end of the year, you must also file taxes for personally, but also your business. When you incorporate your business, you’ll get what’s called an Employer Identification Number (EIN) number. This EIN number is similar to your Social Security number. It is what identifies you company with the IRS. So if any customer asks for a 1099 form, you would given them your EIN number, instead of your Social Security.
This separate legal entity is great. If it did not exist, any issues related to your company would be directly the owner’s responsibility. But all is not perfect, since someone uneducated about owning a business might mix their personal, and business transactions. This is a big no no! Intermingling the two can lead to legal, and tax disasters. This is what is known as “piercing the corporate veil”.
PIERCING THE CORPORATE VEIL WITHOUT EVEN KNOWING IT
Many small business owners get tripped up, and pierce the corporate veil without even knowing it. What do I mean by this? If you created a C Corp, S Corp or LLC; it means you should never mix your personal transactions within your business. You should think of your business as if it wasn’t owned by you. When working for someone else, you must get approval of business expenses.
So anything you purchase for the business should be done via corporate credit cards, a company check or at minimum expensed via an expense report. With an expense report, you then cut a check within the company to pay for those expenses. When paying the business partners, it should be a business check that’s paid out to you personally. This is no different when working for someone else. You’ll get a salary just like when working for an employer.
You should not be writing checks from within your company to pay for personal expenses. This means not paying your home mortgage, groceries, or cable bill. Unless of course these are legitimate expenses within your business. When in doubt of what’s considered legal expenses, ask your accountant. If you don’t have an accountant, yet own a business, I suggest that’s the first advisor you get.
Not only can an accountant assist with the complex taxes, but they will help advise you on some of the legal issues. If in doubt pay for any item personally. You can always expense to your business later.
When owning a business you don’t have to become an expert in accounting and tax law, but you should at least understand the basics.
If you keep your personal and business expenses separated, it will protect you from legal trouble. If you pierce the corporate veil too much, a judge may determine you personally liable for business transactions. This is not to say you should purposely fraud partners, vendors or customers. This can also pierce the veil and there are many other examples in which this could happen.
Bottom line: If you have a business generating any significant income, and serious about growing the business you should incorporate. While the initial costs, reoccurring costs and overhead is not minor it will save you many legal hassles in the future, with also tax advantages to boot!
FURTHER THOUGHTS AND QUESTIONS FOR ALL OF YOU
I asked Investor Junkie to share his thoughts on this subject because he’s an entrepreneur and I’ve seen so many companies get in trouble with using a company’s funds for their own personal use. There are also many of us online entrepreneurs who might be tempted to use company funds to buy a car they don’t need, go on a vacation that’s irrelevant to the business and so forth. There’s such a gray area and I can see the temptation!
For example, I’m going on a European cruise this fall. Since I will be meeting up with a couple potential clients for the Yakezie Network, is my round-trip plane ticket fully expensable? What about at least one hotel night stay a the 4 Seasons in Barcelona? And how about my entire cruise itself if I so happen to meet more customers on the ship?
One online friend earns probably north of $30,000 a month from his site, but takes only a $5,000 a month income so he doesn’t have to pay payroll taxes of 12.4% on the remaining $25,000 a month. That’s $37,200 in payroll taxes saved on $300,000 a year in annual income that flows to retained earnings on the corporate balance sheet. The problem is, with only a $60,000 a year income, it’s going to be difficult getting more than a $200,000 a mortgage, which doesn’t buy very much house where he lives. Does he buy a house using his company’s funds and pierce the corporate veil? After all, it is his company.
Can one load up their company with loss making assets such as an income property to offset profits? Since a corporation is a separate entity, is it considered piercing the corporate veil if a relative or parent is hired to pay for services rendered?
Let’s get this discussion going entrepreneurs and business folk alike!
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Updated for 2016 and beyond.