By Sandra Taylor-Sawyer, Ed.D.: CNJ columnist
At some point in a business’ life the question of when to change legal entities, moving from a sole proprietorship to a corporation, surfaces. There are several schools of thought on this topic.
One is risk. As a sole proprietorship (a single owner business), liability is unlimited. This means personal assets of the owner — such as a home, car, and other personal belongings — are in jeopardy if sued.
The level of risk a product or service offered may cause is another determining factor. An example, a retail store that sells chemicals will have a lower risk than a service business that applies the chemicals. With a greater risk of liability one should consider incorporation. Any business that involves direct contact with the public can have increased risk. Changing from a home-based business to a store front or an increase in sales may also determine a legal structure adjustment.
There are experts whose philosophy dictates that all businesses should incorporate on day one regardless of the type of business. The basis is credit. The rationale: debt will increase since most proprietors self-finance their business. Because of the personal debt, these experts believe debt will be difficult to obtain when the business decides to incorporate. As a corporation, the business is a legal entity in itself, separate from the individual owner.
Another reason to explore a new legal structure is taxes. If profits are beyond reasonable compensation of what a manager would be paid, the tax impact is different for a proprietorship vs. a corporation. A proprietor’s profits are taxed at the self-employment rate of 15.3%. A corporation pays income tax (federal and state withholding) and employment taxes (FICA and unemployment) on the owner’s salary, but the self-employment tax does not apply. Also, the added cost of doing payroll must be considered.
In contrast, a Subchapter S-Corporation will be taxed on profits regardless if the profits are distributed to the owners. A general corporation, known as C-Corp., will pay taxes on profits and the owners will pay taxes when the profits are distributed to them; known as double taxation.
A corporation’s life is perpetual; if the business owner retires or expires the business can continue without dissolving. With a proprietorship or partnership the business will cease once the owner is no longer available.
If a business owner needs capital one may consider forming a corporation. A corporation will allow for multiple owners. New owners can infuse new capital and expertise which can expand the business.
The cost associated with each legal entity varies. A sole proprietorship is easiest and inexpensive to form. A c-corporation is the most difficult, expensive to form, and time consuming. The other legal structures fall somewhere in between the two.
When deciding on which legal structure one must consider the factors as presented: risk, tax requirements, future and financial needs, and the cost to form. There is not one structure for a specific type of business, industry, location or goal. The determining issues are who owns the business and the purpose, using the factors presented.
Sandra Taylor-Sawyer is director of the Small Business Development Center at Clovis Community College. Call the center at 769-4136 or visit www.nmsbdc.org/clovis