Let’s play word association. Or to be more accurate, acronym association. I’ll go first.
“Invasive.” “Confiscatory.” “Heartless.” “Unbending.” “Bureaucratic.” “Dictatorial.” “Arbitrary.” “Capricious.”
Okay, that’s a start. Here’s another one: “Anti-business.”
Or more specifically, anti-sole proprietorship.
If you’ve spent as much time trudging the depths of our nation’s tax code as I have, you reach two inevitable conclusions:
1. The whole colossal, unreadable, internally contradictory thing needs to be demolished;
2. As it stands right now, it treats regular salaried workers worse than it treats anyone else.
No one pays through the nose come April 15 worse than Lunchpail Larry and Cubicle Candice alike. And who benefits while they suffer? Those no-good businessmen, that’s who.
You developed a skill, became an expert in your field, found clients, made them happy, continue to, and now you’re turning profits. The American dream — better living through entrepreneurship. Everything is going great, so should you bother with the extra work and the legality of it all?
If all you do is create a product or perform a service that people love and are willing to pay for, you will be pecked to death by state and federal income taxes. So much so that you’ll want to give up your aspirations of self-determination.
Play The Game
You can rail about the unfairness of this. Or you can do what almost everyone can, but few bother to: play the IRS’s game; only make sure that you’re on the winning team.
In other words, if you own and/or operate a business, incorporate. Create an artificial entity that doesn’t eat, sleep, or breathe. All it does is get tax breaks.
“Tax breaks” is a vague term, but for our purposes, we’ll define it as being taxes that a salaried worker pays that an entrepreneur doesn’t. By the way, it’s not like there’s some special 4-year training period you have to complete to become an official entrepreneur. Nor do you need a prohibitive amount of money. The ranks are wide open. When you incorporate, you reduce the tax liability for you and everyone else who owns a piece of your company.
Say your business loses a massive amount of money in a short time, by incurring an unforeseen, uninsured expenditure like a civil suit. The sole proprietorship could end up owing more money than the business itself is worth. So where would the additional money come from? You, the owner. That’s called personal liability, and it sucks all manner of foodstuffs.
When you structure your business as a corporation, you’re taking advantage of the legal principle of limited liability: (your share of) the business can’t be responsible for any more than what you put into it. For example, if you owned $2,000 worth of Enron shares, and it turned out that the company didn’t really produce anything, the worst that could happen to you as a shareholder was that you’d be out your $2,000 when the stock price fell to $0. No one who sued the company (and there were plenty) could sue you, as an owner, for more than your investment. Now if you were a director of Enron, on the other hand…
This is called the corporate veil, and it really comes in handy on the smaller scale of a you-sized business. Considering that 2/3 of new businesses fail, you have to protect yourself against any inevitable downside. Unless you’re so masochistic that you enjoy having creditors come after your car, house, personal bank accounts, and maybe your baby if it’s healthy and has all its organs.
2 Ways to Incorporate Your Business
If you know even a little bit about this, you might know that there are two common ways for your business to incorporate. The more common one is called an S Corporation, the other is as a limited liability company.
Under either an S corporation or an LLC, your private assets are protected. No one who feels slighted by your company can “sue you for all you’re worth”, as the invective goes. This isn’t the case when you’re a sole proprietor: for legal and tax purposes, you’re indistinguishable from the business itself.
An LLC doesn’t technically pay taxes. Instead, the government taxes the LLC’s (taxable) profits, which are distributed among the owners. Those profits get taxed at the same rate as regular income. Your LLC issues you a K-1 statement, which lists your share of the LLC’s income and expenses, to be transferred to your 1040.
An S corporation is a little more work, but usually worth it.
There are minutes, resolutions, the election of officers, formal financial statements, etc. You’re even supposed to hold an annual shareholder meeting, but that’s not hard to do if you own all the shares.
From a tax standpoint, there’s virtually no difference between an LLC and an S corporation. The biggest difference between them is how the IRS treats excess profits. If you own and operate an S Corporation and pay yourself a “reasonable” salary, the remaining profit is “distributed” to you at the end of the year and isn’t subject to 15.3% self-employment tax. Not so with an LLC.
Other Reasons to Incorporate
Hopefully, your business gets so successful that you end up selling it. Which for most of us is the ultimate goal anyway. Take it from someone who’s been there; while a sole proprietorship is easy to create, it’s a pain to sell.
If you operate your real estate business as a sole proprietorship, you have to sell every single asset individually. If you incorporate, the entire business moves as a unit.
Besides, if your business is viable and the new owner halfway intelligent, the first thing he’ll do is incorporate anyway. Save him the trouble and do the incorporating yourself, then add the incorporation fee into the price. And charge a premium for the privilege, of course.
Even if your business has multiple owners, and even if those owners are just you and a spouse or a sibling, selling your share will remain a snap if you’re incorporated.
Are you ready to play the game?
Or you could just keep filing your annual 1040s, and try to figure out why you’re not getting rich.
Obligatory legal disclaimer: Although most states allow a real estate licensee to operate under a single-member LLC, you should check with your state real estate division to be sure. Ask your attorney or accountant if an LLC or an S Corporation is the right choice for you.