Should I Form An Entity For My Business?
The short answer is yes.
I really intended to be impartial here. In my attempt to transfer these thoughts to my computer screen, I ran through a couple of options. Surely there could be a good reason for some people wanting to remain as sole proprietors. I tried to imagine a business that would not need to have entity protection… (Enter Dream Sequence)
The Best Sole Proprietor Ever
The very best candidate would be a purely online business that offers non-important services to people. It would have very little assets and would be one without any brand recognition. It would have no employees or independent contractors and no real estate or leases. There would be no customer or supplier contracts and no accounts payable. Its owner’s vision for the company wouldn’t be for it to be a separate legal person. There would be no need for succession planning and certainly no need to allow additional investors / owners. And you wouldn’t care about being audited. I still haven’t found that business.
Since this best sole proprietor is online, he/she doesn’t have the risk of someone slipping and falling in the store. By offering services, you avoid product liability. By offering non-important services, you don’t have the potential liability of providing incorrect advice and having your customers rely upon it. Without employees and independent contractors, you don’t have agent liability. Without contracts and accounts payable, you don’t have contract liability. There would be no concern for separating yourself from the business and no interest in growing the business through outside investors. There would be no need to plan for the death, retirement, or other exit of the owner.
Why Insurance Is Not Enough
People can get insurance, right? Why not have an umbrella policy to cover potential claims? If you are a sole proprieter, insurance pays (or doesn’t pay) only after you are sued personally. The time and effort spent defending the lawsuit and forcing the insurance company to pay is a nightmare. Insurance also has limits. A $1,500,000 judgment on a $1,000,000 umbrella policy means your “business” is gone. Furthermore, if you run over someone with your car, the plaintiff can take all of your assets, including those in your “business.” One more point is that having a separate legal entity is cheaper than paying monthly for an umbrella policy.
Lets Talk About Cost
Formation costs vary based on the number of owners. A single-member business is cheaper because of the operating agreement / stockholders agreement. A single-member agreement is about 10 pages long and there are typically no discussions. A multi-member agreement is about 30 pages long, with 5-10 negotiation points to be worked out between the owners. My firm, Houghton, P.A., charges $800 for a single owner corporation or LLC. Multi-member formation costs depend on the negotiations and document iterations, but typically average out around $2,000. There is also an additional filing fee in the State of Florida ($87.50 for a corporation; $125 for an LLC). If you plan to use an accountant, which I would suggest, then expect additional accounting fees in the realm of $1,000 per year.
Do You Have A Business Or A Job?
Ask yourself whether you really have a business or whether you’ve set yourself up with a job. In “The E-Myth Revisited,” Michael Gerber says there are three personalities in every business owner, the entrepreneur, the manager, and the technician. And while the perfect scenario is for those three to be balanced, the truth is that most owners spend the vast majority of their time and energy as the technician. If I have a shoe-making business, I am making the shoes – and that is how I spend my day. If I am a web designer, I design web pages. There is no separate respect for the business. As it happens, this is just as true for larger, well-established businesses and business owners. The psychological impact of taking a step back and viewing your business as something separate from yourself will allow you to spot opportunities that you otherwise would have missed. It will allow you to be the entrepreneur who questions whether new business lines make sense. It will allow you to set up the processes and procedures that make your business function more efficiently.
No Risky Business, No Problem?
So, let’s assume I have a web design business. There is not a ton of liability there. Sure, there may be some liability in terms of accounts payable and other contracts. Sure, there could or could not be some premises liability if you have an office. But, and here is one huge catch, let’s say you run over someone on your way home from work. Your business, your business name, all of the assets of the business, are subject to levy. You see, entity protection works in two ways – it protects your business from risks inherent to your business, but, perhaps more importantly, it protects your business assets from risks inherent to you personally.
Reduced Chances of a Tax Audit
As if you needed another reason, sole proprietorships are the most audited form of business, both by the IRS and by the State of Florida. Presumably, this is for a few reasons: 1) on average, the type of business owners who do not form entities are the type that attempt to cut corners on taxes, 2) it is an easier audit than getting into entity specifics, and 3) their results (in collections) have been better.
OK… One more. As a sole proprietor, you are required to pay self-employment tax of 15.3% on every dollar of net income that you earn, up to $76,200, in addition to income tax. That is nearly $12,000 in tax. If, instead, you form a corporation, then you are able to avoid at least a portion of this self-employment tax by paying yourself a “reasonable” salary. A reasonable salary varies between industries. There is, however, a very real possibility that you are leaving money on the table while remaining unprotected in a sole proprietorship.
If you are interested in forming an entity around your business, give me a call.