Increased audit risks: The IRS knows that it finds more tax mistakes and fraud with solo businesses, so on average, it tends to audit such entities at a somewhat higher rate.
Now, in enumerating these possible drawbacks to operating a business as a sole proprietorship, I’m not trying to scare you off from doing so or talk you into, for example, incorporating. You need to consider which pros and cons may or may not apply to your situation and the type of business you’re envisioning or operating. And you need to consider the alternative entities, like the ones later in this chapter.
Deciding whether to incorporate
A corporation, technically speaking, is a legal entity that’s separate from its founders, managers, and employees; it’s owned by shareholders. Your personal assets are protected in case the corporation is sued. C corporations (the subject of this section) provide the most financial protection to shareholders, but many small businesses choose instead to be S corporations because they’re cheaper to start, easier to maintain, and have just one level of taxation compared with the two levels of taxation for C corporations. (I discuss S corporations in more detail later in this chapter.)
Limited liability companies (LLCs) are an increasingly popular option that offer numerous corporate-like benefits (chief among them liability protection) without some of the costs and downsides. Please be sure to read that important discussion later in this chapter.
Before you call a lawyer or your state government offices to figure out how to incorporate, you need to know that incorporating takes time and costs money. Corporations generally involve the highest costs and most administrative hassles among the range of business entities for you to use. There are fees to incorporate, and each state levies an annual fee that you must pay, even if you have no business income that year. You also have higher legal and accounting costs thanks to the more complex tax rules and filings required of corporations, including the dreaded IRS Form 1120, “U.S. Corporation Income Tax Return” (see the first page of the form in Figure 2-1; the complete, most recent form is located at www.irs.gov/pub/irs-pdf/f1120.pdf).
In some instances, the decision to incorporate is complicated, but in most cases, it need not be a difficult choice. Taxes may be important to the decision but aren’t the only consideration. This section presents an overview of the critical issues to consider. I discuss liability considerations, including whether you can obtain liability insurance for your chosen profession, as well as tax and other considerations.
Courtesy of the Internal Revenue Service
FIGURE 2-1: The corporate tax form — IRS Form 1120 — entails a high degree of difficulty. Shown is page one.
Getting a handle on liability protection
The chief reason to consider incorporating your small business is for purposes of liability protection. Attorneys speak of the “protection of the corporate veil.” Don’t confuse this veil with insurance. You don’t get any insurance when you incorporate. You may need or want to buy liability insurance instead of (or in addition to) incorporating (see the next section for details). Liability protection doesn’t insulate your company from being sued, either.
When you incorporate, the protection of the corporate veil provides you with the separation of your business assets and liabilities from your personal finances in most situations (gross negligence and bad faith being notable counterexamples). You must follow the ground rules, though, for being a corporation.
Why should you care about the separation of personal and business assets and liabilities? Suppose that your business is doing well, and you take out a bank loan to expand. Over the next few years, however, your business ends up in trouble. Before you know it, your company is losing money, and you’re forced to close up shop. If you can’t repay the bank loan because of your business failure, the bank shouldn’t be able to go after your personal assets if you’re incorporated, right?
Unfortunately, many small-business owners who need money find that bankers ask for personal guarantees, which would negate part of the liability protection that comes with incorporation. Additionally, if you play financial games with your company (such as shifting money out of the company in preparation for defaulting on a loan), a bank may legally be able to go after your personal assets. So you must adhere to a host of ground rules and protocols to prove to your state and the IRS that you’re running a bona fide company. For example, you need to keep corporate records and hold an annual meeting — even if it’s just with yourself!
Investigating liability insurance
Before you incorporate, investigate and find out what actions can cause you to be sued. You can do this by asking others in your line of business or advisors who work with companies like yours. Then see whether you can purchase insurance to protect against these potential liabilities. Insurance is potentially superior to incorporation because it pays claims.
Suppose that you perform professional services but make a major mistake that costs someone a lot of money, or worse. Even if you’re incorporated, if someone sues you and wins, your company may have to pay a sizeable settlement. This situation not only costs a great deal of money but also can sink your business. Only insurance can cover such financially destructive claims.
You can also be sued if someone slips and breaks a bone or two. To cover these types of claims, you can purchase a property or premises liability policy from an insurer.