BY JOE DICHIARA
Doing business as a sole proprietor is the absolute worst form of legal entity a business owner can operate under, yet it’s how every business is classified as by IRS immediately after commencing activities.
Most people don’t realize that starting a business comes with some very specific requirements, like registering with certain agencies and keeping books and records. Major decisions need to be made right off the bat, and a lot of times the legal organization of the business gets overlooked in favor of more interesting and exciting activities such as marketing, setting up operations, etc.
Keeping books and legal and accounting issues get pushed off to the side while the business is being built. That’s why over 23 million businesses are operating as sole proprietors today. There is an obvious lack of good information and direction on this topic. All of the government agencies and business incubators I’ve encountered spend little if any time on this subject.
So why is doing business as a sole proprietor so bad? Here’s a few reasons:
• Lack of legal protection;
• Lack of tax planning strategies;
• Social Security tax on net profits;
• Much higher audit risk;
• Hard to transfer to family members; and
• Not being taken seriously.
An LLC can take care of the legal issues, but there is no tax status for an LLC. A single member LLC is taxed as a sole proprietor, plus it cost at least twice as much to form an LLC then establish an S Corp, which is the preferred way of doing business.
The benefits of incorporating and electing “S” status can be substantial, and it only cost $125 to incorporate in New York State.
Incorporating can be done online at Department of State website and getting a federal tax ID number and electing S Status with IRS form 2552 and NYS for CT-6 is free if you do it yourself, but it is important to fill these out correctly so you may want the assistance of an accountant or attorney.
Once established the owner can enjoy:
• Legal asset protection for the owner;
• Substantially reduced IRS audit risk;
• Zero social security tax on profits (a reasonable salary must be taken, but that does not mean all the profits are salary);
• Easy to transfer ownership;
• Corporations are taken more seriously than sole proprietors by banks, insurance companies, the government and the public in general; and
• Even very small businesses netting less than $10,000 per year in profits benefit from S Corp status.
Here is a quick example: Nora owns a small crafts business she runs out of her house. Her sales are $80,000 per year but after expenses, including a deduction for the business use of her home, net profits are only $20,000.
As a sole proprietor Nora is below the poverty level, yet she still has to pay $3,000 in Social Security taxes. She has an IRS audit risk because of the business use of the home, which the IRS does not like, and if there was a lawsuit her personal assets are at stake.
As an S Corp, Nora pays zero Social Security tax and lowers her IRS audit risks substantially because the IRS audits S Corps a lot less than sole proprietors. Plus, she has the legal protection of doing business under a corporate umbrella.
The drawbacks are you may need a pro to do your taxes (also lowering your audit risk), and you have to operate the corporation properly. It has to be operated as a separate legal entity with proper record keeping with all business decisions being documented.
These “drawbacks” can actually be considered good business practices. So if you’re a sole proprietor or you know one, look at the pros and cons of incorporating your business and draw your own, educated conclusion.
Joe DiChiara is a CPA who has been serving small business owners in the metropolitan area for over 35 years. His company, Bedrock Business Builders Corp. specializes in helping entrepreneurs start, build and manage their own small business. Reach him at (661) 752-5639 or visit bedrockbusinessbuilders.com.