As a professional consultant, you spend plenty of time determining how other businesses work. But, how much time have you put into determining the shape of your own business? Choosing the best legal entity for your enterprise will help minimize your risks and maximize your profits. That way, you can concentrate on consulting.
What’s best for your business? That depends. The type of legal entity you choose can affect how hefty your pile of paperwork and administrative duties are, the amount you pay in taxes, and how exposed you are to personal liability in the event of a lawsuit. You don’t want damages that coming out of your own pocket, either in the form of cash or seized assets.
The Most Common Legal Business Structures for Consultants
There are four primary types of business structure you’ll want to consider for your consulting business. Here is a breakdown of what makes each unique:
If you’re the only person involved in your consulting business and if your business is not incorporated, you’re probably already a sole proprietorship. This is usually the case if you’re freelancing or acting as an independent contractor.
What’s great about a sole proprietorship is that, typically, very little paperwork is required. You don’t have to register as a sole proprietor with your state. You may, however, need to file a DBA certificate if you’re operating your business under a name different than your own. DBA stands for “Doing Business As”.
Depending on where you operate, your state may require DBAs to obtain certain licenses and permits.
In the eyes of the law, sole proprietorships are considered to be “pass-through” entities. This means that both your business and personal assets and liabilities are considered one in the same. As a result, you don’t have to file a separate tax return for your business; the profits and losses of that business simply pass through directly into your tax return. When tax time comes around, you just report the business income and expenses on your individual Form 1040, Schedule C. Easy enough. But, keep in mind you will be responsible for withholding necessary income taxes like self-employment taxes, which pay for Medicare and Social Security.
The biggest knock on operating as a sole proprietorship is that it exposes your personal assets to risk. For instance, if a client blames your consulting for financial losses and sues for negligence, your personal assets, including your bank account and house, could be up for grabs if they win. That’s a risk you need to make certain you’re prepared to take.
Limited Liability Company
It may surprise you to learn that Limited Liability Companies (LLCs) are not incorporated businesses. Instead, they’re unincorporated structures that involve one or more owners.
Like a sole proprietorship, all of the LLC’s profit and losses pass through to the owners’ individual tax returns. Personal income and self-employment tax also need to be withheld by each owner. There is also more paperwork involved. The Secretary of State requires you to file the Articles of Organization (there is a fee). And, it’s considered good form to draft an operating agreement for your LLC. This agreement lays out what is expected of each LLC owner.
So, why form an LLC? Unlike sole proprietorships, LLCs offer better asset protection, including shielding owners from personal liability. This can happen if your business gets sued for negligence, caught up in illegal activity, or in the event, one of your co-owners is found responsible for personal wrongdoing.
The only way your personal assets are at risk is if the operation of the LLC “pierces the corporate veil” and it is determined that there is little difference between the owner’s assets and those of the business. In that event, personal assets can be taken. To avoid this, it is important you distinguish yourself from your business, starting with keeping separate bank accounts.
A good rule of thumb is to form an LLC only if there is more than one owner. That’s because a single-owner LLC is generally treated as a “disregarded entity”, where business and personal assets and liabilities are not considered to be separate from each other.
An S Corporation is an incorporated business structure where stock shares are appointed to owners, thus making them shareholders. You can have up to one hundred shareholders in your S corporation. This can be a good structure for consulting businesses, specifically because it can shield your personal assets, as long as you keep business and personal assets separate.
To create an S Corporation, the Secretary of State requires new businesses to file articles of incorporation and pay the filing fee. A board of directions must also be appointed.
As with a sole proprietorship, the profits and losses of the S corporation flow through to the shareholder’s personal tax returns, where it will be taxed at the individual rate instead of the corporate rate. S Corporations can also pay dividends to shareholders. The benefit here is that those dividends are not subject to self-employment tax, resulting in substantial savings for the corporation. However, if a shareholder provides a service to the S Corporation, the corporation must pay the shareholder a salary, which is taxable.
Another benefit S Corporations have is that they avoid the double taxation of C Corporations.
If your top concern is making absolutely sure you cannot be held personally liable for your business’s actions, then a C Corporation may be for you. These are usually large incorporated businesses with many employees and shareholders. And like S Corporations, C Corporations are required to distribute shares of stock in order to appoint their owners, making them shareholders.
As with an S Corporation, the Secretary of State requires you to file articles of incorporation, while also electing a board of directors who will assign business activities to the officers.
Your C Corporation will be required to pay appropriate taxes on all profits. In addition to that, all employees of the C Corporation will also be required to pay taxes on their earned income. Because taxes are happening at two levels here, it creates what is known as double taxation.
However, your C Corporation will not have to pay corporate taxes if it ends up showing a loss for the year. This can happen for unlimited years due to the fact that C Corporations are generally presumed to be for-profit enterprises. Showing a loss can create savings benefits at tax time. But, this is something you should speak with an accountant or tax adviser about for guidance specific to your situation.
Even if you are the only shareholder in your C Corporation, meaning you own a 100% stake, you are exempt from personal liability for business debts and a lawsuit, provided you do not pierce the corporate veil.
Which Structure is Right For You?
When choosing the structure for your consulting business, the first thing to determine is whether or not you want or need to incorporate it. It’s not required. But, it may offer advantages. And, those advantages may outweigh any paperwork or maintenance required by incorporating. Next, consider what each type of entity offers. Are they easy to form? What are the tax ramifications? How much risk are you taking on in the event of a legal dispute?
LLCs tend to be preferred by consultants. That’s because they offer the flexibility of a small operation while also protecting your assets. However, forming and maintaining an LLC requires paperwork and fees. If you would prefer not to deal with that, then a sole proprietorship may before you.
S Corporations are typically more suited for large consulting businesses with several shareholders and employees. It provides the asset protection of an LLC but places more responsibilities on the shareholders.
Unless your consulting business is on the verge of becoming a large firm, chances are a C Corporation is not right for you. They can be unnecessarily large and complex, and don’t offer many advantages beyond what you can get with an LLC or S Corporation.
Ultimately, you are the only one who can decide which business structure is best for you. Whether you’re a business consultant, IT consultant, accountant, or offer general strategy, taking the time to determine your structure now will pay off later.