A business is a legal fiction. It only exists in so far as we and the courts believe it to. It's an entity made of pure thought, even more so than a computer program. When you write a computer program you're causing the computer to take physical actions. When you form a business, you're literally willing a new thing into existence.
This may seem like a trivial point, but you only get the benefits of a business as long as other people believe it exists. What are those benefits, you ask? There are two big things you get by forming a separate business entity:
- limited personal liability for the financial liabilities of the company
- tax incentives
You could just start doing business as yourself. You may have already. You could, in fact, just ignore this whole chapter, and there's nothing really wrong with that. But, you don't get those two things above.
For a freelancer or consultant, there's honestly not a lot of benefit to the limited liability portion. Let's walk through a situation that might happen to you as a software developer. You write a system for a client that processes credit cards, using the latest in PCI-compliant systems like Stripe or Braintree so you're not storing credit card data on the client's servers. You do the best you can do to make it as secure as possible, but let's say there's a bug in the underlying framework. An attacker gets into the client's machines and modifies your code such that it starts skimming credit card numbers.
The credit card company identifies your client's system as the source of the leak and shuts down their merchant account. Your client sues you AND your business for negligence.
The liability shield built into the business might protect you, assuming you included the right language in your contract, but you're still on the hook for paying a defense lawyer. In the chapters on Insurance and Contracts we'll talk about ways to protect yourself, but just know that the business, by default, isn't really there to protect against this kind of liability.
"Limited liability" is much more narrow than that. It actually means you're not liable for debts the business owes by itself. For example, if your business took out a loan to purchase something, and then fell behind on payments and ended up in bankruptcy, your liability for that loan ends at the amount of money you have invested in the business. Unless the bank demanded a personal guarantee from you, of course. In that case you're still on the hook.
The biggest boon when you have a separate business entity is the tax deductions available when you're operating for profit. Businesses are taxed on their profits, not their total revenue (except in some states that have a gross revenue tax). Here's some examples of things you can write off as a business owner that you can't when you're an employee:
- full cost of health care insurance premiums
- full cost of business insurance premiums
- mileage on your car
- new computer equipment
- phone and internet service, including web hosting
- meals with clients
- home office
Any expense the business incurs in the normal course of operations counts as something you can deduct in some way. There are rules surrounding some deductions because they're been abused in the past, but for purposes of this discussion just know that almost every expense is tax free.
Types of Business Entities
Broadly speaking, there are three different types of entities you can start.
Sole Proprietor and Partnership
First you have the defaults. If you just start charging people money for goods or services as yourself, you're by default a Sole Proprietor. The buck starts and stops with you. You reap all the profits from your business, and you're liable for everything your business does, because you are your business. A partnership is the same thing except you have two or more people involved instead of just yourself.
Sole proprietors and partnerships are the original ways to do business, and they're the simplest to form (do nothing). That said, they have a lot of drawbacks, especially around liabilities. Thus, the corporation. Story time: a long time ago people would get together and fund trade expeditions. They would pool their money, take out loans, hire a ship and a crew, and send them out to find riches and trade routes. Exploration is a dangerous game. Sometimes (i.e. all the time) a ship would sink, the crew would disappear, and the banks that gave the group loans would demand their money back. They would find the richest investor and demand compensation, and the courts would give it to them, sometimes to the point of sending investors to debtors' prison.
Investors were naturally hesitant to invest in new expeditions, because the risk of catastrophic loss and subsequent personal loss was so high. So, they got together with their friends on the government and wrote down a way to limit their liability to just the money they put into the business.
A corporation is a separate legal entity from the owners. It doesn't die until it's killed. It can have bank accounts, buy things, sell things, and generally go about conducting business as if it were a sole proprietor, all while protecting the owners from their debtors. To this day, corporations are the most common form of formal business entity.
Modern corporations are great if you want your business to have lots of little shareholders or you want to retain significant money in the business. They also come with all kinds of required formalities, like annual meetings, stock certificates, and other paperwork. Corporations have to file their own tax return and have their own tax brackets. This means you would probably end up paying taxes twice on some portion of your company's revenue, which is not ideal. There are ways to minimize it, but consultants aren't looking for this kind of thing, so a corporation is probably not the best idea for them.
An LLC (Limited Liability Company) is a hybrid between a partnership and a corporation. The owners enjoy limited liability without all of the paperwork that a corporation requires. In trade, they give up the ability to sell shares to the public, among other things.
You can conjure up an LLC in 10 minutes by filling out a form and sending it into your state's Secretary of State along with the registration fee. Bam. New company, born in less time than it takes to buy a cup of coffee.
The rules for the internal workings of an LLC vary by state, but the common ones are:
- File with the state periodically (some states are annual, some are every other year)
- Usually pay some sort of franchise fee or tax
- Don't commingled personal and business assets (i.e. have a separate bank account)
- Don't commit fraud
Every state's LLC law sets out default rules and then allows you to write an Operating Agreement to override them. For all practical purposes, single-member LLCs like your baby consulting company can generally get by with the default rules or a simple agreement like the following:
Yes, you'll be signing a contract by yourself. The point is that you have written processes in place for your business, which helps to enforce the notion in your mind and other peoples minds that the business is in fact a separate entity. Remember, a business only exists if people believe it does.
Taxes and S-Corp Elections
By default, an LLC is a "pass through" entity. The IRS doesn't acknowledge its existence, calling it a "disregarded entity", which means all of the revenues and expenses from the business flow onto your personal tax return and are taxed at the personal rates. Most states don't tax LLCs individually either, except for yearly registration fees, but some states like California have a tax on your gross receipts with a minimum of $800.
When you work for a business as a normal employee, the business reports what they paid you and how much they withheld for taxes to you and the IRS on form W-2. There are three Federal-level taxes on a W-2: Federal income tax, Medicare, and Social Security. As an employee, you only see half of the Medicare and Social Security taxes withheld from your paycheck. Your employer pays the other half and gets to deduct it on their income taxes. Each half of Social Security is 6.2% up to $118,500 in wages, and each half of Medicare is 1.45% on all wages.
As a business owner you are your own employer. This means you get the privilege of paying both halves of Medicare and Social Security, which comes to a total of 15.3% on the first $118,500 in income and 2.9% of every dollar after. You do get to deduct half of that when figuring how much is subject to income tax, but it's still a hefty bite.
Long ago the IRS decided to allow a special type of corporation, called a Sub-chapter S corporation, to reduce how much they pay for Social Security and Medicare. When a corporation elects Sub-chapter S status they agree to certain rules, including pass-through taxation like a partnership or sole proprietor, limited number of shareholders, and rules about the types of stock they can issue and who can own it. In return, they get to decide how much each owner gets paid as wage vs dividend and thus how much self-employment tax they pay.
The IRS allows LLCs to make this same election. Here's an illustration, assuming $100,000 of taxable income and a reasonable wage of $60,000.
|Total SE Tax
By electing S-corp taxation you save yourself $6,160 in taxes. Here's another example, this time assuming $200,000 in taxable wages and $140,000 reasonable salary:
|Total SE Tax
In this case you only save $1,740 because of the wage cap on Social Security.
As you can see, the benefits of S-corp taxation are massive when you have below $200,000 in taxable income per member for the year. They start to phase out at the Social Security wage cap, but there are some big deductions you can take to keep your taxable income near that level.
Save for Taxes!
As you can see, as a successful business owner you are going to be paying taxes. Don't be surprised next April when you see your bill by making estimated payments each quarter. The IRS's due dates for quarterly payments are:
- April 15th
- June 15th
- September 15th
- January 15th
No, these are not calendar quarters, but I have yet to see a good explanation as to why Stick them in your calendar with reminders so you don't forget.
How do you figure out how much to pay? For first year, don't stress about it too much. The IRS doesn't really care that you make uneven payments, just that you pay at least 100% of what you paid last year or 90% of what you need to pay this year by April 15th. Also remember that if you or your spouse had a job at any point in the year you paid at least something in already, so you can subtract that out when figuring out an estimate.
For subsequent years you and your accountant can figure out how much your quarterly payments should be.
In sum, here's how you should organize your business:
- Form an LLC in your state
- Elect S-corp taxation by filing form 2553 with the IRS
- Save for taxes and pay quarterly
In later chapters we're going to talk about the other things you should do to maintain the separation between you and your business, including contracts, banking, and insurance.