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Posted: December 03, 2010

Which business for the self-employed?

Take your pick, but choose wisely

It's no secret that small business is big business in Colorado, constituting nearly 98 percent of the state's businesses and about half of the total employees. During economic turmoil as qualified workers get laid off, they don't sit around; they start businesses.

According to the Small Business Administration, the number of self-employed persons increased by about 25 percent from 2000 to 2007 in Colorado. Colorado's 126,951 small employers and 426,017 self-employed make a significant contribution to the state's economy and their numbers rose while big company employment fell. Perhaps you are one of those growing numbers of self-employed or are considering "hanging up a shingle" and starting your own consultancy or business. The first thing you have to consider is what type of entity you're going to create.

In Colorado, that comes down generally to four main choices: sole proprietorship, a partnership, a limited liability company or a corporation. The corporation breaks down into two categories, S corporation and C corporation. For right now, we will throw out the C corporation because of its potential for double taxation.

The form you choose depends upon you, the goals for your business and to some extent, even your ego. There are advantages and disadvantages to all of them, and in the case of some issues, such as health care, it makes no difference as premiums are deducted as expenses in all four forms.

S corporation
If you turn your taxes over to a traditional accountant, there's a good chance he or she will recommend you form as an S corporation because that's what most of them are set up to do and you can potentially limit the amount of FICA tax you pay. Here's why: Gross income goes into the S corporation. You are an employee of the S corporation and draw a wage, say $60,000 on income of $150,000. While it's true that both you and the S corporation pay equal amounts totaling the 15.3 percent FICA tax on the $60,000 salary, both you and the S corporation doesn't pay FICA on the rest if you treat it as a distribution, i.e. you draw it out. You can even out your tax burden over good and bad years by keeping your salary consistent. However, you must have a reasonable salary for the work that you perform. You cannot avoid FICA merely by taking all income as a distribution.

The FICA savings is the chief advantage of the S corporation but there are a couple other intangibles that might make you choose it. If you are president of a corporation and that's what your title reads on your business card, it feels good. Often banks will negotiate more with a corporation than a partnership on a loan because a loan to corporation is more marketable to a loan committee.

Here's the most important intangible: If you intend to grow the business to being more than just a self-employed entity the corporation form may be right for you. The S corporation has a more formal tax structure that holds value in the entity and not just necessarily with the members involved.

If you are a candle shop and you manufacture candles and you know at some point you'll sell to the biggest candle maker and marketer in the state, you don't want to be sole proprietorship because the entity has the ability to go beyond yourself. It is separate from you, unlike the sole proprietorship.

The downfalls are that for a one- or two-person operation, there is a lot of onerous paperwork that goes with an S corporation. You have to file a separate tax return, have regular payroll checks and accounting for employees and (if applicable), set up a separate pension plan or 401K. You can't deduct a home office with an S corporation; instead the corporation has to pay rent to the owner (yourself) and deduct that. And if you place ownership of an auto into an S corporation, you potentially face much higher auto insurance rates.

Sole proprietor
If you just start your business and hang a shingle, voila, you're a sole proprietorship. All of your formal business organization will amount to what you file on your personal tax return. You are the company. All the income and loss is yours, as is any liabilities that you incur, legal or otherwise. If you get divorced, your spouse may want half of your business in the settlement.

You want to avoid taxes at all costs and you take full advantage of any business expense. The Section 179 depreciation schedule allows you to depreciate on a regular schedule up to $500,000 on vehicles or equipment purchased within a trade or business. In addition, the so-called "Hummer Tax Loophole" allows many heavy SUVs to be fully or partially deductible all at once, up to a $25,000 limit. It is interesting that vehicle weight has been getting bigger to try and get an automobile classified as something that would fit this classification and therefore generate a bigger deduction. By the way, these items are not unique to this entity.

The biggest drawback to a sole proprietorship is how personal legal and debt liability flows 100 percent through to the owner if something goes wrong, as opposed to an LLC, which has partial liability and may be circumstantial.

LLC and partnerships
My preference for the start-up and especially the professional service firm is the LLC, or limited liability company. The limitation of liability for legal challenges and debt collection is a huge reason. As opposed to a generally accepted partnership form, the LLC is granted by a state, which means it can vary by state as some states don't acknowledge them. They enjoy all the business deductions as other entities.

In a general partnership, profit, loss and managerial duties are shared among the partners and each partner is personally liable for partnership debts. The same is true for a limited partnership or LLC, although the limited partners/members share of liability of the partnership is limited. Partnerships do not pay taxes, but must file an informational return. Individual partners report their share of profits and losses on their personal return. With both LLCs and partnerships, administration is easier and special allocations are allowed for partners. Furthermore, valuation discounts could also apply to allow more gifting opportunities. They are a favorite form for private equity groups.

The drawbacks to LLCs are that partners have to pay the full FICA tax and there is an increasing risk of higher fees charged by the states. Look for states, including Colorado, to add more fees onto these types of entities. And finally, LLC partners have to pay quarterly estimated taxes. They don't receive salary that has been pre-deducted. Psychologically, as soon as people see dollars of income, they don't want to let go and it can lead to not paying enough taxes on time, which of course generates back taxes and penalties and interest.

So if you're a builder of companies or a wonderful service provider, look to which entity fits you the best to accomplish the goals necessary to help your business grow.
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