It can certainly be scary: trying to choose a legal structure for your business can seem like confronting a horrible, two-headed monster. One head goes by the name "sole proprietor," while the other is called "corporation." You're not sure which is scarier, and you hope the beast will vanish if you close your eyes and count to ten.
No such luck. In fact, if you don't make a decision, the IRS (speaking of monsters) will do it for you, and you don't want that. You're an IP; you make decisions for yourself.
A sole proprietorship is a business wholly owned by one person, who's known as a sole proprietor. The sole proprietor, moreover, owns all the business' assets in his own name. This means that there's no legal distinction between the sole proprietor's personal and professional possessions.
By contrast, a corporation is a business owned by one or more people, called shareholders. The corporation is treated like a fictional person, a made-up thing that has the power to act, and can therefore assume some of the responsibility for its actions. A corporation can own assets, buy and sell them, hire and fire people, make and lose money, sue and be sued.
In this introduction to business structures, we aim to uncover why you might want to operate as one and not the other. We'll describe the basics of sole proprietorships and corporations; tell you the major advantages and disadvantages of each; and, we hope, get you to think of the choice among business structures as a business opportunity instead of a monster to be wished away.
Sole proprietor is the very simplest business structure: it's what you are if you go into business without doing anything official, a kind of default mode. Legally, the business and the sole proprietor are one and the same. The business' assets are the personal possessions of the sole proprietor, the business' risks are the proprietor's risks, and the business' taxes are recorded simply as an addendum (the Schedule C) to the proprietor's personal tax return. Most IPs operate as sole proprietors.
The Good News
Easy to establish. A few states require sole proprietors to register the name under which they plan to do business or to get a business license, but this isn't much trouble. Fill out a single form and you're done. In most cases all you have to do to be a sole proprietor is own all the business' assets in your own name.
Pay taxes only once. This is a biggie. Because you are your business, you pay income taxes only once -- as an individual. The business does not pay taxes separately. (Your individual tax return includes a Schedule C for your sole proprietor business. You don't fill out a separate corporate return.) We'll soon see that this isn't the case for some types of corporations.
No boss. If you own the business, you're officially the boss, plain and simple.
The Not-So-Good News
Lots of liability. As the sole owner of the business and its assets, you're personally and completely responsible -- that is, legally liable -- for the actions of the business. A legal settlement against you could cost you the business' assets and your personal ones as well. In fact, legally, there's no difference between the two.
If the informality and potential liability of operating a sole proprietorship makes you uncomfortable, consider incorporating your business. To have "incorporated" means that you've filed special papers to create a business that is technically a separate entity from yourself. As we said, a corporation is legally a fictional person. This entity has assets that are separate from your personal assets, can make or lose money separate from your personal savings, and incurs risk (of being sued, for example). The corporation does all these things independently of the person or people who own the corporation, and consequently must also file a special set of tax returns independent from the shareholder's or shareholders' personal returns.
The two basic types of corporation are the S Corporation (S Corp) and the C Corporation (C Corp). In most respects they're identical, so before we discuss the principal difference between them -- the way they're taxed -- let's consider the advantages and disadvantages of the corporation in general.
The Good News
Liability Protection. Because the corporation exists as a legal entity that typically assumes responsibility for the actions of its shareholders and employees, the corporation is also legally liable for them (unless they're criminal acts). If a company fails to pay a debt, for example, the creditor may sue the corporation for payment. If the creditor wins the lawsuit, the court may seize the corporation's assets to pay the debt, but not the assets of the shareholders and employees. A corporation shields its shareholders' personal assets. (Keep in mind, however, that a corporation won't provide you with complete immunity from personal liability; liability insurance might still be a good idea.)
Some IPs think that their businesses will seem more official and therefore garner more business if the abbreviations "Inc." or "Co." follow the name of the business (Sour Sadie's Sex Toys, Inc.). Others say that their experience and skills speak well enough for them. At the very least, incorporating your business suggests that you're committed to it.
Paperwork. Regardless of the kind of corporation you form, you will need to keep more detailed records than the sole proprietor does. The corporation owner(s) must be able to prove that the business is (and remains) a corporation and not some other kind of business, which might be subject to different laws. The distinction becomes especially significant in court: if a judge determines that a corporation's assets are really just the personal property of the corporation owner, for example, the judge can declare the corporation a sham and force the owner to use his personal assets to pay the "corporation's" debt. This is called "piercing the corporate veil."
To form a corporation, you file papers with the Secretary of State of the state where you will do business. These papers (Articles of Incorporation, a Certificate of Incorporation, or a Charter) identify the corporation and its principal players by name. (As a formality, corporations must have shareholders, directors, and officers. Although these positions may, in most states, all be held by one person, they must nonetheless be filled.) Later you'll draw up bylaws, which describe the rules that will govern the operation of the company.
Additional Expenses. Because the corporate structure is more complicated than a sole proprietorship, you will probably need to consult a lawyer and perhaps an accountant as well. Although you're not required to get professional counsel, it's probably a good idea. This represents an additional expense.
Liability Counterargument. Even if you're incorporated, you're not invincible. Clients can try to make you sign their contracts "as an individual," and not as an incorporated business. If the type beneath your name on the contract says "as an individual," you lose the liability protection of incorporation, which was the main reason you incorporated in the first place. Clients will not necessarily try to make you sign as an individual, of course, and when they do, you always have the option to refuse.
The Corporate Taxation Game
As we've already mentioned, the C Corp and the S Corp differ primarily with respect to the way they're taxed. It's a pretty big difference and would probably be the reason you would choose to form an S Corp (which is the form of choice for most IPs who incorporate) rather than a C Corp (which is typically the business structure of choice for big companies with lots of shareholders).
In a sense, the money of the C Corp shareholder always gets taxed twice. Yes,
that's right, a C Corp's revenue is subject to double taxation. The
C Corp pays its own taxes, then may pay a part of the remainder to you,
the shareholder, as dividends. You would pay personal income tax on
your share of the dividends. (IP C Corps don't usually bother with dividends.
Instead, these IPs pay themselves a salary, which comes with its own
considerations: corporate and personal tax brackets sometimes differ,
and the difference may affect the amount of the salary paid.)
November 22, 1999
Written by 1099 Staff
Illustrator: Lawrence San
Production: Keith Gendel
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