If you do freelance work, are a subcontractor, or are just thinking about moving in the direction of self-employment, a question that comes up is should I incorporate? In general, incorporating a business means that you separate yourself from the business so you enjoy limited personal legal responsibility by setting it up as either a Corporation or an LLC. That allows your personal assets to remain safe if the business can’t pay its debts or gets hit with a lawsuit.
Many people don’t realize that owning rental property, building Web sites on the side, or making and selling artwork, for instance, makes them a business owner. Whenever you earn income from a source other than a regular ol’ W-2 job, you’re running a business. The type of business entity you choose is important because it has serious legal and tax consequences.
Should You Incorporate Your Small Business?
Here’s a brief summary of 4 common entities for small businesses:
Business Entity #1: Sole Proprietorship
If you earn money from a business or side gig, and haven’t set yourself up as a Corporation or an LLC, by default you’re a Sole Proprietor. It’s the simplest way to own a business; however, it’s a potentially dangerous one because you’re personally 100% liable for what happens to the business.
Here’s an example: Let’s say you’re a blogger and you spread nasty, untrue rumors about a professional that directly causes them to lose business. They get really ticked, sue you, and take you to court. A jury finds you guilty of libel and a judge orders you to pay $100,000 in damages. Uh-oh. You’ll have to pay up even if you never made a dime in your blogging career.
When it comes to taxes, Sole Proprietors report their business profit or loss on their personal tax return. Depending on the kind of work you do, it may be fine to operate as a Sole Proprietor. But if you have any concerns about legal liability, you should protect yourself by forming a Corporation or an LLC.
Business Entity #2: Partnership
If you have a business with one or more other people, you’re working as a Partnership. It’s similar to a Sole Proprietorship in that each partner is personally liable for lawsuits against the business. Each partner reports their share of the profit or loss of the business on their personal income tax returns.
In general, I don’t recommend doing business as a Partnership because it’s too risky. Not only are you responsible for your own actions, but you’re on hook if a partner messes up and causes a lawsuit or takes on business debt that you’re unaware of. Forming a Corporation or an LLC is a safer option.
Business Entity #3: Corporation
A Corporation is an entity completely separate from its owners with its own legal and tax responsibilities. A Corporation actually continues to exist even if the ownership dies or changes. You can attract investors by offering the sale of shares of company stock. There’s limited liability for the officers, employees, and shareholders from business debt or lawsuits filed against the business.
A general or C Corporation conducts business, has net profit or losses, pays taxes, and distributes profit to its shareholders. The IRS taxes both corporate profits and dividends paid to shareholders, which are often referred to as “double taxation.”
You can avoid double taxation by creating an S Corporation instead. An S Corp allows the owners or shareholders to report their portion of the profit or loss from the business on their personal income tax returns. In most cases, if you plan to take all the profits from your business, an S Corp is the way to go.
Business Entity #4: Limited Liability Company (LLC)
A Limited Liability Company or LLC is an independent legal entity that’s allowed by state statue and is governed by an operating agreement. The owners of an LLC are called members and they receive limited personal liability from business debts and lawsuits. Additionally, an LLC has flexibility when it comes to paying taxes because it can file either as a Corporation, a Partnership, or a Sole Proprietorship. This makes it easier to manage your business accounts and personal accounts separately.
What Does it Cost to Incorporate?
There’s some expense to setting up a Corporation or an LLC and renewing your status each year. You can do it yourself, hire a professional, or use a company to help you get started. The price at sites like legalzoom.com and incorporate.com start at about $100 to complete the initial paperwork. Each state has its own fee structure for annual fees, but it’s typically not more than a few hundred dollars per year. If you have questions about the right kind of entity to set up, be sure to consult with a attorney. The cost to incorporate is well worth the protection you’ll receive as you grow your business and exposure to legal liability.
Image credit: SalFalko