On Monday I started a series of blog entries called Going Indpendent, where I plan on looking at the legal, accounting, and - most importantly - the psychological issues one must contemplate when trying to decide whether or not to go independent. In today's blog entry I'd like to look at the first steps one must take when going independent - setting up a business. This talk may be U.S.-focused, as it looks at business models available here in the states.
Before diving into the options one has for setting up a business, I'd like to start with two quotes from colleagues that do a great job of highlighting the pros and cons of being employed. First, a strong case for being employed:
I personally enjoy being a corp employee. Great benefits! Decent pay. Great hours—no required O/T and paid time-and-a-half O/T. Low stress because deadlines are mostly internal and flexible. Paid training, travel, and expenses. Paid vacation. Paid sick time and even personal time. Work from home if need/want to on occasion. Get to work with and lead team(s). Paid to play with new technologies. Paid high-speed internet. Paid cell phone. Pension plan. Matching 50% to 60% 401(k) plan. Great people to work with. Job security/regular income. More or less guaranteed increases.
The above quote illustrates many of the benefits of being employed - a regular paycheck, vacation time, a steady cash flow, etc. But these advantages of employment are oftentimes employer-specific, as another colleague relates:
Unfortunately I am an employee and none of those things apply to me apart from regular pay cheque (so far, been shaky in the past). I still have to worry about cashflow (I have been pretty much 3/4 sales for 18 months now to prevent us going under), do get benefits but not greatest (2.5% into my pension and ... healthcare) but compare that to what others doing similar job get (even at same company)..., all of my vacations have been interrupted by either someone calling to notify me of some redundancies or a problem only I can fix (not always the case but noone seems to have brains, energy or confidence to sort things out on their own).
Not surprisingly, satisfaction at work has a lot to do with one's work environment. The point being, if you are miserable at work, the answer is not necessarily to go independent - it might be to just find another employer.
Types of Businesses
In the U.S. there are different models one can use when starting a business. These different models have different legal, accounting, and tax implications. The most common business models used for self-employed individuals are:
- Sole proprietorship
- Limited Liability Company (LLC)
- S Corporation
- C Corporation
What business model to choose depends on a number of factors, such as tax implications, liability issues, whether or not you plan on hiring other employees, how many individuals you want to let claim an ownership in the business, etc. Over the next few sections we'll briefly look at each of these business models and discuss some of the pros and cons. Before continuing on, please remember that I am not a lawyer nor an accountant. My comments stem only from my research on the matter, and discussions with my lawyer and accountant. Be certain to discuss these matters and your options with a lawyer and accountant you trust before pursuing any of these business options.
The first (and simplest) type of business model is known as a sole proprietorship. This is a business owned by one person - yourself. The benefits of a sole proprietorship is in its accounting and legal simplicity. You don't need to fill out any forms or pay any special dues for a sole proprietorship (as you do with, say, a corporation or LLC). Your business income is reported on the 1040 Schedule C. There are a couple downsides to sole proprietorships:
- You are liable for the business! That is, say you need to buy $50,000 worth of equipment. You place an order and agree to pay on a schedule where you pay, say, $5,000 a month for 11 months. Now, imagine that the business fails after three months, and you close down shop after paying only $15,000 of the agreed upon $55,000. Well, guess what? You still owe $40,000, and the company you owe it to can come after your personal assets (like your car, home, etc.) to recoup their loss. Another, perhaps more applicable example: you decide to go independent as an independent consultant. In your first job you create an intranet application for a company that let's them manage their Web site structure. Due to a bug, when the client attempts to delete a single file, it deletes their entire Web site contents, which they hadn't backed up. If they decide to sue you for lost content/time/etc., your butt and your assets are on the line.
- Taxes are high. As a self-employed person, you'll need to pay self-employment tax on your net Schedule C income. This tax (called employment tax) is paid by your employer when you're working for someone else. When you work for yourself, you must pay it! Bummer, eh? (This is true for all business models, by the way. The comment is not specific to sole-proprietorships, but rather working for yourself!)
Limited Liability Company (LLC)
A Limited Liability Company (LLC) can be owned by a single individual, multiple partners, or even corporations - in either case, these owners are referred to as managers. The benefit of an LLC is that the managers have limited liability in the company. Returning to our earlier example, if your business was an LLC and you were sued by a client for code that deleted their entire Web site, only the business and its assets would be up for grabs - your personal assets, separate from the business, could not be touched. From my understanding, LLCs vary on a state-by-state basis. States differ on who can be members, what types of businesses can form LLCs, and so forth. The cost and paperwork for establishing an LLC differs from state to state. For individually owned LLCs, income is reported via the 1040 Form, Schedule C.
A partnership is a business owned by two or more individuals. The parties involved in the partnership all contribute to the business and are expected to share in the profits or losses. The IRS does not treat partnerships as a taxable entity; rather, each partner must file his or her share of the profit or loss on their own tax return. Form 1065 is used to report income or loss from a partnership.
Things get a bit more complex if you are married and your spouse works with/for you. If your spouse work with you in your business, they are a partner. If your spouse is an employee, working for you, then the business can remain a sole-proprietorship, but you'll need to pay social-security, medicare, and other such taxes for your spouse. If you run a business jointly with your spouse, be sure to get all the tax and legal issues straightened out with an attorney and accountant.
S and C Corporations
A corporation is a separate entity that is formed to run a business. The ownership of a corporation is divided into a number of shares. A corporation is owned by shareholders. An S corporation is a special type of corporation in place for small businesses. It can have at most 75 shareholders, and does not require as much bookkeeping or paper filing as a C corporation. There are also shareholder restrictions with an S corporation, such as: shareholders must be U.S. citizens; partnerships or corporations cannot own shares; there can only be one class of stock; and others. A C Corporation is a corporation without the limitations placed upon an S-corp.
The benefit of a coporation is that it is, legally, a separate entity from its owners. That means the corporation assumes its own liability. A corporation is taxed as a separate entity as well. When you do work for a client, the client pays the corporation. You make yourself an employee of the corporation, and receive an annual salary. Since you are an employee of the corporation, the corporation must pay social-security, Medicate, and employement tax on your salary, just as any large company does for its employees.
Corporations are useful in a number of situations, such as:
- Hiring employees
- Having several individuals own a share of the company (such as family members, investors, etc.)
Corporations also have some useful tax advantages. For example, a corporation could setup a 401(k) retirement plan for its employee(s), where it matches employee contributions.
The downside of corporations is that the paperwork and fees to setup a corporation are much higher than establishing an LLC, sole-proprietorship, or partnership. In addition to the paperwork for setting up a corporation, additional quarterly and/or annual paperwork is needed as well.
When deciding whether or not to go independent, it is important to have an understanding of the legal issues you will need to address, one of which includes forming the suitable business model, be it a sole-proprietorship, an LLC, a partnership, or a corporation (likely an S-corp). Before making any decisions, take the time to research your options - there is plenty of information online at IRS.gov and your state's Secretary of State Web site. Once you have "done your homework," be sure to sit down with an accountant and lawyer that you trust, and discuss the legal and tax implications for the various choices you have. Also realize that forming an LLC or corporation requires paperwork and filing fees, so expect to pay between several hundred and several thousand dollars to accomplish this, depending on the state you live in and your lawyer/accountant's rates.
In my next Going Independent entry I'll turn from the legal issues to the accounting issues, examining how self-employed individuals are taxed. It's different enough from the way employed individuals are taxed, enough so that a discussion on the psychological issues is warranted. Until then!