Choosing Your Entity Type

Self-Employment can be complicated!

One of the best things you can do for yourself, if you have any sort of side gigs, blogging for money – any type of self-employment income, is to formalize the relationship of your work, by choosing your entity type. As an individual, you can easily file a Schedule C, using your regular 1099 income, deducting the direct expenses, and being done with it.

If, however, you want a better tax environment, you might want to create a more formal business structure to receive your income and protect your assets.

There are several entities you can use to help do this; some are more effective than others. The main types are:

• sole proprietorships
• partnerships
• limited partnerships
• LLC’s
• Corporations (both C-Corp and S-Corp)

Depending on your state of residence, and the state where you choose to establish your entity (they don’t necessarily have to be the same), some of these entities may or may not actually be available to you. There are a number of websites that can help you do a proper job of choosing your entity type and they can also help you form it. While they are not going to do this for free, these companies can save the money you spend a dozen times over by helping you avoid some common traps that as an inexperienced person, you might not realize are there.  Keep in mind that there will be state registration fees as well, so this is not a process to be undertaken lightly.

What type of entity is best?

Sole proprietorships and partnerships are the simplest of the types, and they are the least protective. That is: you pay taxes on your share of the income, and you are personally liable for the entire amount of any business debt and claims.

Limited partnerships are expensive to obtain and maintain; I wouldn’t recommend this to the budding entrepreneur. An LLC has a general manager who handles all the details of day-to-day operation; however the limited partners are not liable for business debts or claims.

Corporations and LLC’s do limit the owners’ personal liability for any court judgments or debts created by the business, but they are a bit more complex and difficult to set up. And in fact, the corporation is an independent entity that survives independently of the owner who controls and manages it. The C-Corporation pays tax on its own profits, and the business owners only pay tax on their personal tax returns for money they receive from the corporation (in salaries, bonuses, etc.). The S-Corporation does not pay tax on its profits (at a federal level, though states laws can easily differ), and the income flows directly through to the individual who reports it on his income tax return.  The C-Corporation files a separate tax return on a Form 1120, and the S-Corporation (even though it doesn’t pay taxes) reports its income on a Form 1120S.

Observing the corporate formalities

Today, the President and Treasurer of my corporation, Pro-Count, Inc. observed the corporate formalities. What does that mean? A corporation, being a separate entity with a separate life, must be run by elected officers. The elected officers of my corporation are me (the President) and Mr. BFTROU (Treasurer). We both hold director status, and once a year, the Board of Directors must hold an annual meeting. Since our corporation was formed on approximately this date in 1996, we hold our Board of Directors meeting around this time every year. It’s a good time to plan what we expect for the coming year and make corporate resolutions. So, that’s what we did.

While this year, our meeting was held at Chili’s, we did set a formal goal to have one of our directors’ meetings not too far in the future, in the middle of the Atlantic Ocean. Sounds good to me! For us, cruising’s where it’s at.  We also decided that we are going to establish a Section 105 Healthcare Reimbursement Arrangement, so the corporation can pay our medical expenses for us.  While this will definitely save us in tax money, it’s not exactly “free” money.  Somebody (mostly Mr. BFTROU) has to actually earn the money before it can be spent on health care or anything else.  We just hope that there’s enough to pay the healthcare costs AND actually, you know, have some left over for us to buy groceries.

After this meeting, we will draft a document detailing the minutes of the meeting, just as someone would with any formal meeting, we will both sign it, and we will have observed the corporate formalities. This is very important because the IRS takes this sort of thing very seriously. If you are going to obtain the tax advantages of having a corporate entity, they want to see that you aren’t doing it just in name, but in actuality behaving as a business. If, in fact, you don’t observe these formalities, the IRS can perform an act called “piercing the corporate veil” which will change all that corporate protection into personal liability for every aspect of your business.  That is not an appealing thought.

Due to the vagaries of Mr. BFTROU’s employment, we have always needed a corporation to maintain organization. So, as President and Boss Lady of the corp, I am happy to make sure we Observe the Corporate Formalities every year at this time.

If you should decide to use a Corporation or LLC to “contain” your business activities, be sure you observe the corporate formalities too.