Re-evaluating your business format

Three years ago you started doing business as a sole proprietor. In light of your exposure to personal liability, is a sole proprietorship still the best legal format for you?

Or, perhaps 5 years ago you set up an S corporation because you anticipated losing money during the start-up phase. Now your business is on a solid footing and can afford to put aside a chunk of cash for future expansion. Is this the time to convert to a regular corporation so you can save on taxes?

Decisions, decisions. It's tempting to stick to the tried and true, but it can pay to at least consider the alternatives from time to time.

As you probably know, if you're doing business as a sole proprietorship or partnership, you're personally liable for all business debts and any judgments that a court awards against your business. This means all your personal assets - your home, savings and car - are at risk. Therefore, it may be better to switch to a form of legal entity that limits your personal liability. You will get this benefit by setting up an S corporation, regular corporation or limited liability company (LLC), which is the newest way to do business.

If you're already enjoying the advantages of limited personal liability, think about whether another format - which also confers that advantage - will better suit your needs. For example, you might consider changing from an S corporation to a regular corporation or an LLC.

With so many types of business entities, picking the one that's best for you can be confusing. To sort it out, ask yourself three basic questions: * Do I need to limit my personal liability? * Does it make sense for my business to pay income tax, rather than reporting all the income on my personal tax returns and those of the other owners? *What expenses or paperwork will I incur?

Limited liability For many businesses, a sole proprietorship or partnership works well. This is especially true if you can find and afford insurance to cover all foreseeable risks, and if it's highly unlikely the business will become insolvent. However, affordable insurance may not always be available, and the financial course of the business may be unpredictable. Therefore, you may want to you reorganize your business as a corporation or LLC. That way, you usually cannot lose more than the money you invest in the business.

Be aware, however, that while you can limit your personal liability, you cannot eliminate it altogether. With a corporation or LLC, your personal assets will still be at risk if any of the following occurs: * You personally guarantee a business debt, and the business cannot pay it. * The business does not pay the IRS income taxes and Social Security payments it withholds from employee paychecks - and then the business runs out of money. * You negligently injure a customer and the corporation or LLC doesn't carry enough insurance to pay a large judgment against the business. In this example, you will not be liable if an employee causes the injury and you are not personally involved.

Taxes Sole proprietorships and partnerships do not pay federal income tax on their profits. Profits and losses pass through to the owners who report these items on their tax returns.

If, for example, you are a sole proprietor and your business earns $50,000 after you pay expenses, you will report the income on Schedule C and add it to your other income. If the business has a $10,000 loss, you can use the loss to offset income from another source, such as your spouse's salary if you file a joint return.

Similarly, a partnership does not pay a federal income tax. It reports each partner's share of profits and losses to the IRS and the partners deal with this on their tax returns.

Corporations and LLCs may allow you more flexibility in how you handle the federal income tax on profits and losses. In an S corporation, shareholders are taxed the same as partners. If, for example, four shareholders own equal shares of stock and the corporation earns $100,000 one year, each shareholder will report $25,000 of income on his or her tax return.

A LLC works much the same with one important difference: the members of the LLC can agree to allocate income in different proportions than the amounts they have invested in the company. For example, you can agree to allocate $40,000 of income to one member and $20,000 to each of the other three, even if all four members have equal stakes in the business. This tax flexibility is the main reason for predictions that the LLC soon will become the preferred method of doing business for most small and mid-sized companies.

A regular corporation is a separate tax entity and is required to pay federal income tax if it earns and retains profits. This seems like a major disadvantage, but it can actually lead to a useful strategy.

At the lower levels of income, the corporate-tax rates are likely to be lower than your personal tax rates. If the corporation has money that it may need in future years to pay for expansion or a new building, it can make sense to leave some of the money in the corporate bank account rather than distribute it to shareholders. Let the corporation pay tax at the lower rate.

This tax strategy (sometimes called income splitting) can get complicated, so you'll want to get advice from a CPA or other tax professional.

Expenses and paperwork The legal costs for starting and running a business as a sole proprietorship or partnership are minimal, and the paperwork usually is quite simple. Basically, you order a taxpayer's ID number from the IRS and you register your business name with a state or county agency. However, if you have a partnership, it's usually a good idea to put together a brief partnership agreement as well.

Setting up and operating a corporation or LLC is a bit more expensive and complicated. In addition to getting a tax ID number, a corporation or LLC will usually need to file a registration document with the state government. And if your business has two or more owners, you should have a signed shareholders' agreement for a corporation or an operating agreement for an LLC. A corporation will need to file an annual report with detailed financial information. An LLC also may need to file an annual report, but it will have to provide little or no financial information.

Tax returns each year can be more cumbersome, leading to time and expense beyond what you'd expect as a sole proprietorship or partnership. Still, given the potential benefits a business can derive by running as a corporation or LLC, cost and paperwork rarely should be the primary factor in deciding which route to choose.

Finally, never lose sight of the most important legal principle of all: "If it ain't broke, don't fix it."

Fred S. Steingold practices law in Ann Arbor, Mich.

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