Throwing caution to the wind, you’ve done it. You started your own business, you’re sticking it to the man, you are your own boss, you’ve grabbed life by the horns and you love it. You wake up every day with a smile on your face, and as your business grows so does your pride.
Then one day you receive a summons in the mail. Remember that guy 8 weeks ago who came to one of your classes on how to butcher a pig and had to leave because he was allergic to chickens? Well, turns out he had to go to the hospital, racked up a bunch of medical debt, and now he’s suing you because you didn’t explicitly state that there were chickens on the premises. You think to yourself that this guy needs to take a hike for not realizing that a FARM might have CHICKENS on it, but you might be surprised to see that the legal system is probably going to side with him. You know how companies that sell hot coffee have to put a warning on the cup that the hot coffee is hot? Yeah, it’s like that.
The fact is, if you are in business for yourself the chances are very high that you will eventually be sued. How much you panic when you are sued depends to a great extent on how your business was organized when you started out. If you picked the wrong organization chicken guy can torpedo your business, with the right one you’ll hardly break a sweat. I’m now going to go through a few of the options available to you, along with their tax and liability implications (we’ll be doing a pioneers only podcast which will go much more in depth on this soon). Here we go:
A sole proprietorship can only have one owner, and the business cannot be transferred (it ceases to exist at the owner’s death). This is the easiest business to set up, with no real paperwork (except maybe with your local town), no substantial extra tax filing requirements, and no liability protection. This means the owner’s personal assets are exposed without limitation to any and all liabilities related to the business. Remember the chicken guy? If you are a sole proprietorship he’s gunning for everything you own.
Liability protection: None
Tax implications: Some. File an extra schedule which attaches to your personal income tax return (Schedule C or Schedule F, depending on your business activity). The owner’s personal funds and the business funds can co-mingle.
Corporations allow for the limited liability of their owners, but require the most paperwork, and the most ongoing accounting effort. Corporate assets must be kept separate from owner assets (including cash in the bank), paperwork has to be filed with the state when the corporation forms (and usually on an annual basis every year it is open), all kinds of records must be maintained, the corporation has to file its own income tax return and, and the income is subject to double taxation (once by the corp and then again by the owners when they receive the profit).
Liability protection: Tons. If you do things properly a disgruntled employee or customer can only go after the business assets. The owner has $10,000,000 in the bank and the business only has $400 in assets? Chicken guy can only get $400 (in most cases).
Tax implications: Tons. Corporations have to file form 1120 by the 15th day of the 3rd month after its fiscal year ends (March 15th for calendar year corps). The corporation pays income taxes on its profit and then the owner pays taxes again when that income is distributed to the owners in the form of dividends. That means you might be paying more than 35% in taxes the first time and then more than 40% on that same money again when you receive it. OUCH.
If you are planning on going into business with several other people, you should consider starting a partnership instead of a corporation. The main advantage here is you avoid the double taxation of a corporation. The main disadvantage is that the Liability protection is usually weaker, although there are several options available here, such as: if all the partners actively participate in the business activity the entity is considered a General Partnership for tax purposes (by default), this means the owners are all liable for the business debts and/or liabilities. What if you have a rich uncle who is going to invest some case for a stake in the business but isn’t going to be actively involved? Then you can have a Limited Partnership, where the members are divided up into general and limited members, the limited ones have the liability protection but can’t participate. Chicken guy? He can go after all of the general partner’s personal assets but none of the rich uncle’s assets.
Liability protection: ?????? It all depends how the partnership is organized and on it’s operating agreement.
Tax implication: Moderate. The partnership has to file form 1065 by the 15th day of the 4th month after the close of its fiscal year (April 15th for calendar year entities) but the income is not subject to the double taxation that Corporate income is, instead the partnership passes the income to the partners and they pay the income tax on their personal return.
But wait, what about a Limited Liability Company (LLC)? What about S-Corporations? What is a dba anyway? Why is an operating agreement so important? What option do I have if my rich uncle wants his revocable trust to invest in my business? What is this Form 8832 I keep hearing about? Do I file an 83(b) election? Good questions. Better listen to the Pioneers only podcast for the answers.