Incorporating Your Business: Part I

(originally written for The Water Trough, Ed Drozda’s fabulous website):

Have you just started a business and been wondering whether or not to incorporate?  Or freelancing for a while and wondering if now is the time to do it?

What are the pros, cons, choices? LLC, S Corp, L3C, R2D2 – my head, she is spinning.

The turning of the year is a good time to review your options.

Preliminaries

In most situations incorporating* is an option not a requirement.  You are a freelance architect, you are an architect with your wife, you are an architect with your wife and your mistress – you may incorporate but you do not have to.

When would you have to? You are going to be a publicly traded company, say on the New York Stock Exchange. (I have precious few of those.  Actually – none. )

(* technically LLC’s and partnerships do not incorporate per se; for instance an LLC “organizes”. For simplicity’s sake I am considering LLC’s and partnerships as “incorporated” for the purposes of this article.)

Liability Protection

One reason businesses incorporate is liability.  You’ve heard it; we are a “litigious society.  You are a sole proprietor if you run your own biz and are not  incorporated, or even if you are simply freelancing.  Because your business has no distinct legal identity,  your personal assets are fair game if the business is sued.  MartWall gets a judgment against JC Waters for improper installation of a sump pump and resultant flooding – MartWall can look to JC’s personal cash, investments, art collection to satisfy the judgment.

If JC instead was JC, Inc. then Mallwart could only look to his business assets.  He is “shielded” (nice armor JC).

Liability protection is nice – but do you need to?  If your assets consist of a rented apartment, your dog and some loose change, well, what do you have at risk? It also depends on the profession – if you are a one-woman show building small websites there’s less exposure then say, making kids’ toys.

Do not assume that simply adding “inc.” to your name gives you an invincible corporate shield.  If you are covered by your state under a “professional corporation” or “professional service corporation” statute then you will need malpractice or similar insurance to protect your personal assets from professional liability.  Each state deliniates professional corporations differently.  Lawyers, accountants and physicians are most commonly included in the category.  Rhode Island does not include social workers as a professional field for this purpose but some states do.

In any case, the corporate shield will still protect you for “slip and fall” type events. Planning on gross negligence, malfeasance or delinquent payment of payroll taxes? Sorry, no matter what your business structure you cannot count on protection.

Owner Compensation

Important!  If you are a corporation you will be paid a salary (hopefully!). Most LLC’s and partnerships are more like sole proprietors – the active and major owners receive a “draw” from the business (hopefully!) and not salary.  Often they need to pay estimated taxes since they do not have any salary withholding.

Some of you prefer a structured approach and appreciate knowing you have (at least some of) your taxes taken out through payroll.  Others are comfortable “paying as you go” and being responsible for estimated taxes.  What doesn’t work is not being accountable for your choice.  Choose a corporation, then don’t dodge salary by just taking money at will.  You’ll end up with a higher tax bill, and make your accountant cranky as well.  Choose an LLC and dodge the estimated taxes – recognize that you will be behind the eight ball next year and the penalties will accumulate.   By the time you pay your 2011 tax bill you’re halfway into 2012.  If you can never keep up then you may need to look at the viability of your business model , but I have had clients who had the money, they just did not get around to paying.

Both liability and compensation are complex subjects; I hope I have helped by telling you “the least you need to know.”

Next Up:  Tax Implications of Different Business Structures

NOTE: Every situation is different, and federal and state tax and business laws are subject to change.  This article is presented exclusively for informational purposes and is not intended to substitute for obtaining tax, financial or legal advice from an accountant, lawyer or other business professional.