Self-employed? When to graduate from sole proprietorship

June 8, 2011

When Darin Edmonds started Waterproofing Solutions, Inc. earlier this year he knew making a go of it wouldn’t be easy in a struggling economy. But he was determined to get things off on the right foot, and to him part of doing that was putting a wall between his personal and business assets by setting up a Subchapter S Corporation.

“When I began in this business 21 years ago it was okay for me to start out as a sole proprietor. At this stage in my life, when I have personal assets to protect, that’s no longer a sensible option,” says the 46-year-old Corona, California, contractor.

Whether they are running a small side business, investing in real estate, or are established professional service or trade professionals like Edmonds, go-it-alone, self-employed individuals typically start out as sole proprietors because it’s easy and relatively uncomplicated. Under a sole proprietorship — or general partnership if there is more than one owner –a business can get started simply by hanging out a shingle.

By contrast, while separate business entities such as limited liability companies or Subchapter S Corporations can shield personal assets and offer potential tax benefits, they also come with more paperwork and cost. Edmonds paid nearly $3,000 to have a legal professional set up his corporation and file the appropriate paperwork with the state, and will need to pay state annual fees as well. His accounting costs are also likely to be higher. “The peace of mind is well worth it,” he says.

Not everyone needs to form a separate business entity, says Johanna Sweaney Salt, a certified public accountant and partner at Kaufman Schmid Gray & Salt in Claremont, California. “There isn’t a lot of trouble a portrait photographer can get into, and there is always professional liability or umbrella coverage as a backup,” says Sweaney Salt, who nonetheless cautions that people should consult an attorney on such issues. “A lot of business owners complicate things when they really don’t have to.”

Others believe that those who don’t cordon off business and personal assets face a potential legal minefield, even for seemingly low-risk businesses.

“Let’s say you’re a sole proprietor owner of a printing shop who sends an employee out to get some office supplies,” says Phoenix, Arizona attorney Richard Keyt, whose firm sets up an average of over 450 businesses a year, most of them LLCs. “If that employee runs a red light and hits someone, your personal assets could be used to satisfy any legal judgment.”

Even without a written partnership agreement, two or more people can create what is called a common law general partnership by going into business together. When that happens, says Keyt, both partners are 100 percent liable for all the partnership’s debts and obligations. “People who engage in business activity or real estate investment should do so through an entity that protects the owners from the debts and obligations of the business,” he asserts.

In addition to shielding personal assets, separate business arrangements can also offer more flexibility when it comes to taxes. For example owners of Subchapter S Corporations, a common format for professional service businesses such as accountants, attorneys, or physicians, can receive compensation in the form of dividend distributions. Such distributions aren’t subject to Social Security tax, which is 10.4 percent of the first $106,800 in wages this year and 12.4 percent in 2012. The Medicare tax adds on an additional 2.9 percent, with no compensation cap. Employees pay half those amounts, but the self-employed foot the entire bill.

While taking distributions instead of salary can save business owners thousands of dollars in Social Security and Medicare taxes, doing so excessively could send up a red flag to the IRS. “What I tell people is to pay yourself a salary that is commensurate with what you’d have to pay someone to do your job. After that, you can look at taking distributions,” says Sweaney Salt.

Contrary to popular perception you don’t need to be incorporated to use a Subchapter S tax structure, according to Keyt. Owners of LLCs can elect to file under this method, or choose from three other taxation arrangements.

Greater tax flexibility is one reason Keyt maintains that most businesses are better off setting up shop as limited liability companies than corporations. They also require fewer formalities than a corporation, such as annual shareholder and board of director meetings and filing an annual report with the state.

“Corporations are better under certain limited circumstances, such as when business owners anticipate a public offering,” he says. “But for most businesses the limited liability company is the way to go.” Because each business’s situation is different, though, it’s a good idea to consult with your own legal or tax adviser before making a decision.

 

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[…] Self-employed? When to Graduate from Sole Proprietorship By Richard Keyt, on June 9th, 2011 Reuters Wealth – Shedding Light on Personal Finance:  “Whether they are running a small side business, investing in real estate, or are established professional service or trade professionals like Edmonds, go-it-alone, self-employed individuals typically start out as sole proprietors because it’s easy and relatively uncomplicated.  Others believe that those who don’t cordon off business and personal assets face a potential legal….” […]

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