A key issue to consider when starting out as a consultant is identifying the legal form under which you will operate. There are several options available, which will be briefly summarized in this article. This is NOT legal advice, but you may use this article as background information for a visit to your legal advisor.
A common form for consulting businesses is the sole proprietorship. It’s common because it is perhaps the easiest method for starting a business. “Sole” means that there is only one owner. There are no partners, silent or otherwise. Other features of the sole proprietorship:
- No legal papers are required if you use your own name (i.e. Jane Doe Consulting) – although in some states and counties you may be required to file a fictitious business name statement (also known as a “d/b/a”)
- A sole proprietor is taxed as an individual. No separate income tax returns are needed; you report your income and expenses on Schedule C of IRS Form 1040
- Creditors can come after you personally for any debts incurred by your consulting business
Any consulting business with more than one owner that is neither incorporated nor set up as an LLC is by default a partnership. As Renata Rafferty noted in a previous issue of this enewsletter, a partnership is the business equivalent of a marriage.
As with the sole proprietorship, partners are taxed as individuals. And, as with a sole proprietorship, there is no legal protection; partners accept equal responsibility for consulting business commitments and debts. Other features of a partnership:
- Your partnership must secure a Federal Employment Identification Number from the Internal Revenue Service
- The tax return for a partnership is a separate form but the partnership itself pays no taxes; each partner reports his or her share of the profits or losses on their individual tax return
- Although not legally required, you should have a formal contract which specifies each partner’s investment and what happens if the partnership is terminated, a partner dies or there is a conflict
There are two types of partnerships: general and limited. Consulting businesses are most likely to be general partnerships.
A corporation provides protection from personal liability because it exists as a separate entity apart from you as an individual. The corporation, not you, is responsible for its actions and debts. You are simply an employee of the corporation (even if you are the majority stockholder).
There are two forms of corporations:
- An S corporation lets you enjoy the limited liability features of a corporation, but pay income taxes just as you might as a sole proprietor or a partner. Business profits are reported on your personal tax returns. The S corporation itself does not pay any federal income tax, although a co-owned S corporation must file an informational tax return like a partnership to tell the IRS what each shareholder’s portion of the corporate income is. Some states tax S corporations just as they would a C corporation.
- In a C corporation, the company itself is taxed on business profits. Owners pay individual income tax only on money that they draw from the corporation as salary, bonuses or dividends.
You’ll want to discuss with your legal advisor which form of corporate structure is best for your firm.
Limited Liability Corporation
The LLC is a business ownership structure that provides the owners of the consulting business with the same tax treatment sole proprietors and partnerships receive along with the personal liability protection you would find in a corporation. You can form an LLC with only one person (except in Massachusetts and the District of Columbia) or with several people.
Unlike a sole proprietorship and partnership, most if not all states require a filing fee for creating an LLC. Some states also have annual fees. Depending on your state, and your situation, this may be a very small price to pay for the liability protection and tax advantages of the LLC.
Each state may have slightly different statutes that govern LLCs. You will want to do some research or check with your legal advisor regarding any restrictions in your state.
Fare well, and farewell for this week …