Is it time for you to break up with your Sole Prop?

It’s so easy to fall in love with your Sole Proprietorship (because, who doesn’t love simplicity?) but I encourage you to break up with your SP as soon as you decide you’re in business to stay.

I know… breaking up is hard to do, but sometimes, love isn’t enough. 

A Sole Prop, which “springs” into being the moment you make your first business transaction (yup, it really is that simple), leaves you and your personal assets exposed to creditors because there is virtually no difference between YOU and YOUR BUSINESS. That means, as a Sole Prop, you ARE the business, which also means you’re also personally liable for any legal actions brought against your business.

Ouch.

We’re talking home, car, investments, bank account balances, your kids’ college savings account… all of it is vulnerable to any misstep you may make in the course of doing business.

So what’s an S-Prop owner like you supposed to do?

Put on a veil, of course.

The Corporate Veil

The corporate veil is a lot like a bridal veil–thin and transparent–except you don’t wear it on your head. (I’m sure you knew that.) It’s a legal concept that’s intended to protect you, a “shareholder of the corporation” from liability incurred by the corp. But if that veil is “pierced,” the shareholder(s) can be held personally liable for the company’s debts and wrongdoing.

So, keep this in mind as we discuss the differences between an LLC and an S-Corp: your choice of business entity will only protect you as long as you separate yourself and your personal activities from the your business. For small business owners in particular, that means keeping your personal assets (money, bank accounts, expenses, investments, etc.) completely separate from your business. As in, completely.

The C-Corp

First, a little background info: A tradition corporation (C-Corp) is considered an entirely separate entity from its shareholders. Legally, a corporation is a considered a “person” in the eyes of the law. This means that it’s the corporation itself, not its shareholders, that is held liable for the actions and debts incurred by the business, but only so long as that pretty veil stays intact.

With regards to taxation, C-Corps are dealt a double whammy: First, the corporation pays taxes on its annual earnings. AND any dividends payed out by the corp incur income tax liabilities for the shareholders who receive those dividends, even though tax was already paid at the corporate level.

It gets way more complicated but since this article is intended for small business owners like you, we’ll end our discussion about the C-Corp here.

The S-Corporation (C-Corp Lite)

An S-Corp is considered a “pass through” entity because it does away with the double taxation whammy that C-Corps are hit with. This means that all corporate income, losses, deductions, and credits pass through to the shareholder(s) for income tax purposes.

S-Corps can have no more than 100 shareholders and have only one class of stock, among other requirements (you must be a U.S. citizen and you can’t be a bank or insurance company).

As the single shareholder or “owner” of an S-Corp, you must pay yourself a “reasonable” salary plus  “distributions” from any additional profits the corporation may earn. Be careful here because if you try to dupe the IRS by not taking what’s considered a reasonable salary (so as to pay less in taxes), you risk piercing the corporate veil.

Similarly, if you commingle personal and business expenses, that lovely corporate veil could come tumbling to the ground and your company would then be treated as a traditional C-Corp and that means… double whammy time.

The Limited Liability Company

The limited liability company (LLC) is a hybrid structure, offering many of the benefits of a Sole Prop with the limited liability protection that an S-Corp provides. This means you file an individual tax return as the sole member/owner of the LLC. The LLC itself is not taxed. As a Single Member LLC you’ll be required to pay self-employment tax on any income derived from the LLC, which will require you to make quarterly estimated payments to the IRS.

Keep in mind that you risk losing your protection from liability if you pierce the corporate veil. Single member LLCs must take extreme measures to show the IRS that they’re operating real companies and are not just trying to dupe the system. 

LLC or S-Corp?

I knew you were going to ask me this. Ok, I’m a lawyer, but I’m not your lawyer, remember (I have to say that in order to cover my own assets) and one of the reasons I’m hedging here is because each state has its own rules when it comes to business entities. That’s why I recommend you visit the website of your state’s Secretary of State to find out the law that’s relevant to you.

Generally speaking, however, an LLC has the advantages of being easy to form on your own. An S-Corp, however, is a more complicated structure and it’s best to seek the advice and services of an attorney familiar with the laws in your jurisdiction if you decide to go that route.

No matter what you decide, here’s your BIG FAT TAKEAWAY: don’t mess with the IRS. Keep a meticulous set of books and do not commingle your personal and business banking. In fact, whether you’re still a Sole Prop or you’ve transition to LLC status, I suggest constructing a brick wall between you and your business. Keep everything separate and accounted for. You know, so you can sleep at night.

Ready to form an LLC?

Here’s the good news: It’s possible to do it yourself. My “DIY LLC TOOLKIT” walks you through the process of registering your LLC yourself.  (Look Ma, no lawyer!) DIY your LLC HERE .