QUESTION: I have been operating as a sole proprietor but have been advised to incorporate. What is your opinion?
ANSWER: You have been given good advice. Operating as a sole proprietor or partnership exposes your personal assets, in addition to business assets, should you be sued for damages as a result of your business dealings. By incorporating or forming a limited liability company, commonly called an LLC, you shield your personal assets.
Let’s take a look at two common legal entity options for small businesses.
The LLC is easier and less expensive to set up and simpler to maintain and remain compliant with applicable business laws. With the LLC, you adopt an operating agreement allowing the owners to operate in whatever fashion they prefer.
A C corporation may be preferable if you will be seeking outside financing through the issuance of common stock. With a C corporation, you must adopt articles of incorporation, select corporate officers, elect a board of directors, hold board meetings and record minutes of the meetings.
Both the LLC or an incorporated entity can elect to be taxed as an S corporation where earnings are passed through to the owners and taxed at their individual tax rates, some of which can be treated as a distribution of profits versus salary. Profit distributions are not subject to the FICA taxes.
The IRS is looking for the S corporation to have wages that are reasonable for the type of work being performed, and must be reported as such on IRS form W-2. It is important to understand that an S corporation is merely a tax choice election you make to change from a proprietorship, partnership or C corporation.
The LLC is more appropriate for business owners desiring maximum management flexibility to avoid onerous corporate paperwork, separate income tax filings, and have no plans for taking their company public.
S corporations are limited to 100 shareholders, but the LLC has no such restrictions.
These are just some of the differences between the two entities. Usually either is preferable to a sole proprietorship or partnership arrangement.
You are advised to seek the counsel of a licensed attorney or tax accountant to ensure your selection matches your individual situation and long-term business strategy.