SOP Friday: Getting Started – The Form of Your Business
Karl Palachuk / Karl Palachuk
The first step in defining your relationship with your client is to define who you are. Are you a sole proprietor? Are you a corporation? An LLC? Something else?
There are really only a few ways to define yourself. And, really, the two default methods are sole proprietor and S-Corp. We’ll discuss why below. Pretty much everyone starts out as a sole proprietor. Once you get to a certain size, or a certain salary, then S-Corp makes sense.
|Image courtesy of cooldesign / FreeDigitalPhotos.net|
To your clients, only two things matter:
“To whom do I make the check?”
“Do I need to send 1099s at the end of the year?”
Other than that, the only time you really need to pay attention to how your business is legally defined is in your service agreements. Of particular importance is the question of getting out of the way of Uncle Sam.
Forming Your Consultancy
I’m sure you’re a very nice person. But if I were to engage in business with you, I’d want to make sure that your personal “stuff ” doesn’t get all mixed up with my personal “stuff.” If you’ve ever been a landlord, you know what I mean. In business, we need to separate our personal financial life from our professional financial life.
In general, I think that sole proprietors should re-address the question of incorporation every few years. In particular, if you are successful, then revisiting the benefits is in order.
Another area affected by your business form is your status as an employer. When you hire people, then you have a whole new world of taxes and forms and filings. And now you have your personal stuff exposed to your employees’ personal stuff.
Important Safety Tip: Don’t Mess With the IRS
People go bankrupt when they ignore the IRS’s instructions. This is not for you.
You need to be very careful to make sure that your service agreements are written so that you cannot be considered an employee of your clients. You can say “I’m not.”
But that only goes so far. The IRS rules change all the time, but two issues will always affect independent consultants.
First, the question of whether the client should be withholding taxes from your “paycheck.” Second, the question of whether you can take a home office deduction. On both questions I’m deep into the “play it safe” school of thought.
We’re not going to look at the home office deduction very closely as it’s not the focus of this post. But you need to talk to your CPA or Enrolled Agent and take his advice. As for your Uncle, go to http://www.irs.gov and do a search of “home office.”
On the question of employee versus independent contractor, there are several items you should have in your service agreements that define this relationship. Again, to find out the latest rules and regs, go to http:// www.irs.gov and search for “Employee or Independent Contractor?” You might also look at IRS form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.”
Just so you know, your Uncle doesn’t care how you see yourself or your relationship with the client. Uncle Sam has some very specific ideas about whether or not you’re an employee. The general rule is: If the client controls what will be done and how it will be done, then the client is your employer.
Of course this is broken down into specific discussions. For example, if the client tells you where to be, when to be there, how to get the job done, what tools to use, who to hire, where to buy supplies, and in what sequence work must be performed, then you are an employee.
Similarly, if the client pays for training, you might be an employee.
You might look at the IRS publications and find yourself on a borderline for one or more regulations. That’s where contracts or service agreements come in. The IRS specifically states that one of the criteria for defining the relationship is to specify that relationship in a contract.
So, you see why it’s important to make sure you never do any work without some kind of agreement. Even a basic “Credit Agreement” should cover the basics of the relationship. If anyone balks at signing this, you can tell them two things. First, you won’t work without it. And, second, one of the goals is to define your relationship so they don’t have to withhold taxes and put you on their payroll.
As for the longer service agreements, just make sure you cover all the major points the IRS might want to look at. State very specifically that you, the consultant, will determine what needs to be done, what tools are necessary, the order in which work will be performed, etc. Also state very plainly that you are a contractor and not an employee, and that you’ll pay your own taxes.
And that’s the key to success – who’s paying all those taxes? After all, the IRS does not exist to make the world a better place (which is good, because they suck at it). The IRS exists to collect various kinds of taxes. You don’t have to specify that you’ll pay your Federal taxes, and your state taxes, and your unemployment taxes, etc. But it goes a long ways to have a signed agreement that both you and the client know that you are paying your taxes.
If you are the kind of consultant who actually “goes to work” at a client’s office, has a desk to sit at, and you perform most or all of your work there, you need to be particularly careful about these regulations. You also need to be extremely careful about taking a home office deduction.
The bottom line: Find out what the current rules are and rely on professionals for advice. The tax business is just as fast-paced as the computer business. By the time something gets printed, it’s probably out of date. Find a good Certified Public Accountant or Enrolled Agent to advise you on these matters. And make sure you have a lawyer review your service agreements!
Define Yourself: Sole Proprietor
Perhaps the “default configuration” for an independent contractor is to be a sole proprietor. That means that you are just you for tax purposes. Part of you runs a business, and that part of you has to fill out Schedule C on your income taxes.
Legally it means that you personally are doing business with each of your clients. There is no entity between you and your clients, such as a corporation. Unless your business name is your name, then you need to file a DBA (“Doing Business As”) or Fictitious Business Name filing with some government agency.
For example, my business started out as a sole proprietorship. I was Karl W. Palachuk, DBA KPEnterprises. That allowed me to get a bank account under the name KPEnterprises. But it was still associated with MY social security number. Clients could write checks to KPEnterprises or to Karl Palachuk. It didn’t matter because we were one and the same.
You can grow very large and remain a sole proprietor. If you ask your clients you might find some surprisingly large companies that are really sole proprietorships.
You can have employees, buy equipment, and depreciate assets. You can do 99% of all the things any other business does.
The advantage of being a sole proprietor is that it’s easy. You just start selling services and goods. You pay your bills, you collect money. If you make a profit, that goes onto your personal tax return and you pay taxes.
If you have a professional do your taxes, it’s certainly cheaper to do one extra Schedule C than to do a corporate tax return in addition to a personal tax return. So there’s an advantage there.
The disadvantages of a sole proprietorship (in my opinion) are all financial. First, your business is your personal life. Your “stuff ” is mixed up with your clients’ “stuff.” In particular, if your client is also a sole proprietor, then their personal stuff is mixed with your personal stuff.
I know that bad things almost never happen. In more than 15 years in my business (seven of them as a sole proprietor), I never even had a small hint of a problem along these lines. Nobody came after my house, no one put a lien on the contents of my garage, etc. But it is a fact that a sole proprietorship is just you personally and you need to be aware of that.
You can limit your exposure to lawsuits by purchasing Errors and Omissions insurance. I believe lawsuits are rare, but you still need to take seriously the possibility that someone will sue your business.
A second disadvantage to a sole proprietorship is the self-employment tax. This falls into the category of “Don’t get me started!” If you are an employee, roughly 7.5% of your wages goes to Social Security, where it is immediately loaned to the Federal Government for research on wasteful spending habits of political hacks. But you’re not alone. Your employer matches this amount. So, really, a number equivalent to 15% of your income is flushed down the government toilet.
When you are self-employed (as a sole proprietor is), you get to pay both sides of this, which is fine. If you were a corporation, you would also pay both sides, but you the person and you the corporation would each pay 7.5%. But here’s the bad news:
As a sole proprietor, all of your profit is considered your personal income. If you earn $60,000, you pay Social Security taxes on $60,000. If you make $90,000, you pay Social Security on all $90,000.
If you were an S-Corp, you’d pay yourself a salary and pay the Social Security only on your salary. The rest of the profit from the business would flow to you as “dividends.” So, let’s say you pay yourself that very reasonable $60,000 salary. You pay the Social Security on $60,000.
But you don’t pay the Social Security on the remaining $30,000. Fifteen percent of $30,000 is $4,500! That’s a chunk of change. You’d still pay your regular tax rate on that $30,000, but not the Social Security. Note that you don’t pay Social Security taxes after a certain income level (currently around $114,000, but this goes up every year). Your numbers may be very different. See http://www.ssa.gov/policy/docs/quickfacts/prog_highlights/.
The point is simple, however. There’s a lot of money at stake here and you should give some serious consideration to how your company is formed. Note that you cannot pay yourself a miserably low salary to avoid Social Security taxes. The basic rule for the IRS is pretty simple. If you do something just to avoid taxes, it’s not allowed. So you can’t pay yourself minimum wage and take $50,000 in dividends.
Again, don’t mess with the IRS.
But also remember that you are allowed to take normal, reasonable, legal actions to reduce your taxes. Creating a corporation for your business is certainly a normal business activity.
I am not a tax professional. Don’t do something just because I presented some ideas here. Find a qualified tax professional and go over the numbers. If you’re in that $60,000-$115,000 range, you might save yourself some money.
At a minimum, don’t dismiss the idea because it seems complicated or tax prep will become more expensive. A good tax pro will always save you money.
Define Yourself: S-Corp
When you decide to incorporate your business, you automatically form a Subchapter C Corporation or C-Corp. You must then file Federal form 2553 in order to “elect” to become a Subchapter S Corporation or S-Corp.
The primary difference between the two, for small entities, is that C-Corps pay taxes on the corporation’s profits and stockholders also pay taxes on any dividend disbursements. With an S-Corp, the corporation does not pay taxes. It files a tax form to determine what the profit is, then that profit flows to the income calculation on the stockholders’ personal income tax form.
In other words, with a C-Corp your income is taxed twice. There are other advantages for C-Corps that make sense for large entities. But for closely held companies (e.g., you, or you and a spouse, or you and one other person) the S-Corp is really the only option to consider.
The key benefit of an S-Corp is that you can avoid paying the Social Security or Self Employment Tax on a portion of your income. See the discussion of Sole Proprietorships, above. There are also several deductions available as an S-Corp that are not available as a Sole Proprietor.
Another major benefit of the S-Corp form of business is that the business is an entity unto itself. In fact, legally it is a person, which is bizarre. With a corporation, you personally have a relationship with the corporation and the corporation has a relationship with your clients. So you have this layer that protects your stuff from their stuff.
With a corporation, you have a certain level of liability protection. If someone sues the business, they can’t normally get to your personal possessions. I say “normally” because you have to take certain actions to maintain this “corporate veil.” If you treat the corporation like your personal ATM and don’t treat it like a corporation, the courts are likely to say that you did not maintain it as a corporation. So that puts your possessions back out there for lawsuits.
S-Corps don’t make sense when you’re first starting out unless you got some great long-term, highly profitable contracts. Generally speaking, you need to maintain a certain level of profitability—-and expect that to continue—-before you incorporate.
Note also that corporate tax rates vary from state to state. There may be minimum taxes due, even in a year when the corporation loses money.
If you are considering a corporation, find a tax pro who deals with corporations. Agree to pay an hourly fee and sit down with your financial information and “run the numbers.” Get a best-guess estimate of what you’d pay in taxes as an S-Corp versus a sole proprietor.
Finding a great tax professional is extremely important. And we tend to become personally attached to these folks. But your primary concern needs to be your business.
And it may be the case that you need to find “the next level” of skill and ability in a tax professional so that your business can move to the next level.
One final note on S-Corps. If you grow and are successful, you will eventually form an S-Corp. If you always stay just one person, you may choose not to incorporate.
But if you hire people and start growing, there are too many advantages to not incorporate.
Define Yourself: LLC, Partnerships, etc.
Once you move away from Sole Proprietorship and S-Corp, there’s whole alphabet soup of options available, including:
• General Partnership
• Limited Partnership
• Limited Liability Partnership
• Limited Liability Company
• and additional entities available in individual states.
Partnerships are generally to be avoided. They are easy to set up, but they provide no protection of your personal stuff from your own business partner. So, if things go bad, they can go very bad. If you invest in real estate, revisit this issue for that enterprise, but not for your technical consulting business.
LLCs aren’t bad. They act a lot like corporations, but allow profits to be allocated by means other than percent of business owned. They tend to be more expensive to create than a corporation, and state laws governing LLCs can be different from Federal laws.
Again, I sound like a broken record here, but you need to do your research and check with your tax and legal advisers.
Generally, you should have a solid business reason for choosing the form of your business. And for almost everyone, that choice will come down to being either a sole proprietor or an S-Corp. If someone suggests that you create some other entity, make sure you understand why.
It never hurts to get a second opinion.
How you define your form of business will have little direct effect on how you write your Service Agreements or operate your business. Remember to play your role at all times. If you’re a sole proprietor, act like a sole proprietor. If you’re an S-Corp, act like an S-Corp. And so on.
Some clients will request a W-9 form, which is a statement relieving them of the responsibility of withholding taxes from your “pay.” You should fill these out for anyone who asks. If you are a Sole Proprietor, you must give this information to each client. Consider filling out one form and photocopying it for each new client.
Good luck out there.
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About this Series
SOP Friday – or Standard Operating System Friday – is a series dedicated to helping small computer consulting firms develop the right processes and procedures to
create a successful and profitable consulting business.
Find out more about the series, and view the complete “table of contents” for SOP Friday at SmallBizThoughts.com.
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All material Copyright (c) 2006-2013 Karl W. Palachuk unless otherwise noted.