Often overlooked in the choice on entity analysis is the sole proprietorship option, but sometimes the best thing to do is nothing at all. To be a sole proprietor, all you have to do is walk outside (or stay in your home office) and start your business. It is the easiest, most affordable, simplest method out there, and yet it is often the one most discouraged. Two things drive businesses – the desire to save on taxes and the desire to protect against liability. While these two drivers are often correct, the benefits that come with incorporation are often overplayed. If you are the sole owner1 and your business is small, being a sole proprietor might be the right thing for you.
With respect to taxes, sole proprietors are treated the same way as a single member LLC, which is as a disregarded entity2. When you make income, you report it on your individual tax return on a Schedule C. This is the same for single member LLCs and sole proprietorships, so between a single member LLC and a sole proprietorship, the tax results are the same. In fact, you may be a little better off as a sole proprietor because you do not have to file a business privilege tax with the Alabama Department of State.
For S-Corps, if you go back a couple of articles, you will see that there may be a FICA tax benefit that the S-Corporation has over the LLCs. S-Corporations also have this advantage over sole proprietorships. A sole proprietorship pays self-employment tax on its earnings, just as LLC members do who are active in the business. However, the caveat about this tax savings plan (and all tax savings plans generally) is that you must have income to have a taxable income problem. Occasionally, you will see entrepreneurs getting ahead of themselves, attempting to solve problems that do not exist and structuring for tax problems that may or may not ever come to fruition. Why do you want to spend money on professional fees, filing fees and the time of incorporation when you have no tax savings? Sometimes doing nothing is the best and right answer.
This gets us to the other main driver in incorporation — the liability shield. The liability protection is real. If you maintain the corporate formalities (e.g. annual meetings, proper capitalization, acting in the name of the corporation, etc.), then courts by and large will respect the corporate veil. They will not make you personally liable for the corporation’s acts. That is a real benefit. If you have an employee who does something negligently or a partner who commits malpractice, then a court will only be able to find the entity liable – not the individual. Potentially, the corporate veil can be the difference between losing your house or not losing your house, so we can and should be respectful of the corporate veil.3
However, the liability shield is not a superman’s cape that you can put on to protect you from all of the nefarious traps out there for business people. Specifically, the corporate veil does not protect you from your own personal actions. What does this mean for the entrepreneur?
- If you sign a personal guaranty on a loan, you are still liable for the debt regardless of whether it is used in the business or not. For liability purposes, if the business cannot pay, you will be required to pay. Almost all bank debt for small businesses requires a personal guaranty, and the corporate veil will not protect you from this personally guaranteed debt.
- Similarly, if you sign a lease, you are often required to sign as a guarantor or as an individual. This liability, again, is not protected by incorporation, and if the business cannot meet its rent obligation, you will be required to pay out of your personal assets.
- If you are negligent in a car accident, even if you were performing duties on behalf of your corporation or acting within the scope of your employment, you are still liable for your own negligent acts regardless of your incorporation status.
- Along those same lines, if you are a professional (lawyer, doctor, etc.) and you commit malpractice, you are still liable for your own acts.
So when reviewing your choice of entity status, ask yourself if you are really able to protect yourself from any real liability. If you are a consultant or other small business owner and your financial obligations are personally guaranteed, what liability realistically exists that your incorporation will protect you from? Often small companies are so small that any tort (i.e. not contractual) liability is personal to the owners themselves. As a consequence, again, an incorporation is a waste of time and money.
Entrepreneurs need to be able to ask these questions of themselves because attorneys are not great evaluators of this risk and will typically recommend incorporation regardless of the merits. If you are a cynic, you may think that this is because lawyers want the fees. However, I can assure you that no one is getting rich forming small, single member LLCs. The reason attorneys will almost always recommend some form of incorporation is because if the remote situation/worst case scenario manifests itself, the attorney will at a minimum look foolish for not recommending a corporation and at worst potentially have some malpractice exposure.
Thus, I can usually only recommend sole proprietorships in the abstract. Clients need to be informed about the issue and savvy enough to take responsibility for not incorporating. However, if they do take this approach, they can usually get started more quickly and more easily and come out in the same position as if they had incorporated.
One of the great things about America is the ease with which you can start a business. If you want to start a business tomorrow, go for it. From a legal standpoint, sometimes the only thing you need to do is get a business license from city hall. You do not need to get lost in the nuances of choice of entity. Sometimes the best advice is the easiest advice. Just Do It.
Goodrich Law Firm, LLC
1 If you have partners, shareholders or some other co-owner, you need to form a company so that you have the respective rights and duties of ownership clearly established. Otherwise, you are a partnership which carries fiduciary obligations which may or may not be appropriate for the situation.
2 In other words, you do not have to file a separate tax return.
3 Also note that as a general rule, the corporate veil is the same between an LLC and a corporation.