Sole proprietors cannot take in a partner or co-owner, and their personal assets are at risk. Worse, you could form a general partnership by accident, without realizing it, and unknowingly allow other people to put you at risk of losing everything. A more formal business form is wise if what you sell or do is not straightforward, someone could sue your business, you want to share business resources with others, you want to take in a partner, or you might someday want to sell the business.
Choosing the right form for your business has a wide array of effects, including but not limited to:
- what you can treat as deductible expenses
- how you file tax returns
- whether you are legally responsible for mistakes made by someone else
- how insulated your personal assets are from business liabilities
People often do business as a sole proprietor if they are in business alone, providing something relatively straightforward, with practically no risk that anyone would ever sue. Sole proprietors include Schedule C in their personal tax returns every year, but not an entire separate tax return. It takes minimal fuss: get some business licenses, and maybe register a Doing Business As (DBA) name for the business with the state, county and/or city. On the whole, of all forms of business, this is the least hassle.
But if anyone does sue the business, or if your business gets into financial trouble, there is no boundary between you and the business. Your personal bank accounts, real estate, cars, etc. are on the line. You also cannot take in a partner to help you grow the business.
Although I am not an attorney or accountant, because of my experience I am sometimes asked for suggestions about choosing a form of business. When I asked for guidance myself, lawyers answered with a bias toward legal solidity, without enough regard for accounting and reporting complexities their choices impose. Accountants answered with a bias toward tax efficiency, without enough regard for liability or asset protection issues. To make a good decision, you need to know both angles so you can determine which business form fits best.
Faced with this question, I provide an outline of what I regard as the high points. The person who asks me still needs to consult a legal professional to make a final decision, but they have a clearer notion of what to ask their attorney.
Once upon a time I was asked for advice about the right business form for a doctor who believed he was a sole proprietor. Two other doctors joined his practice. Because all three share the same religion, the doctor accepted them on a handshake, with no formal agreement.
After a while, the new doctors left, set up their own practice elsewhere in the same building, and took a large number of his patients with them. To get through the resulting crunch, his wife has been handling the reception desk and other clerical duties. It occurred to the doctor and his wife that perhaps they need to handle the business side of his practice differently.
Obviously, his business form is not the only problem, but this case study is confined to that issue.
When the doctor accepted partners, he formed a general partnership without realizing it. If he shares resources with other doctors without setting up a formal business, that forms a general partnership. In this business form, each of the doctors is liable for any mistakes made by the other doctors and their personal assets are at risk. In other words, if any of the doctors terribly harmed a patient, the patient could sue all three doctors for everything they own.
A case similar to this situation is often cited as an example. A few dentists decided to share a receptionist and waiting room without making formal business arrangements. They did not realize that made them a general partnership until one of them got into trouble and the others found themselves pulled in. The same thing would apply in any similar sharing situation, such as mechanics who share a garage and set of tools without setting up a formal business. It is perilously easy to accidentally create a general partnership in the eyes of the IRS and courts, and the consequences can be financially and legally ruinous.
This doctor was lucky. Nothing terrible happened while the other doctors worked with him, and he is wisely looking at what changes he should make instead of simply going back to his previous structure.
Options On the Table
Now that the doctor is on his own again, he could work as a sole proprietor again. But considering that doctors are at high risk of getting sued, he probably should at least have either a corporation or a limited liability company (LLC) to insulate personal belongings somewhat from any lawsuits that happen in his professional life. After all, he is not the only person relying on those assets. His wife could lose everything, too, simply because he has not protected personal assets from professional risks. (For reasons outside the scope of this article, limited partnership was not under consideration in this case.)
Although giving the business a more formal structure involves extra cost and bother, there are some compensations. In addition to better asset protection, it is easier to take appropriate business deductions on tax returns when using a well suited business form. As the doctor ages, he may want to bring another doctor into the practice again, or sell it when he is ready to retire. Having a joint practice or selling his practice will be much cleaner when it is a corporation or LLC.
The main reason for choosing a corporation would be depth of legal precedent. LLCs are newer and have much less case law behind them.
If Choice is a Corporation
Personally, I thought a corporation would not be the best fit in this instance, but for some people it would be. A “subchapter C” (normal) corporation leads to double taxation on some income–the corporation pays tax on its profits, and the owner (the doctor) pays tax again on any profits that are paid out to him as dividends. For this reason, if he chose to incorporate, I suggested a “subchapter S” corporation. C-corporations can have more owners, issue more than one class of shares, hold more retained earnings, and own more kinds of assets or other businesses. Those abilities are important for large companies but are not factors for his medical practice.
After forming the corporation, he would file a form with the IRS declaring subchapter S status. When times are bad, losses would “flow through” from the S-corporation to his personal tax return, up to the amount in any one year that he uses to “capitalize” the company when he forms it. In one of my businesses, I only capitalized with $1000. When I had a bad year, that loss stretched out $1000 per year on my personal tax return as a deduction until it was used up.
When times are good, he would pay himself a salary from the corporation at a rate that is appropriate for his profession. If there is more profit in the company, that “flows through” to his personal tax return and is taxed as his income, but no payroll tax is due on it. This is a tax break he does not get when he does business as a sole proprietor.
If Choice is Limited Liability Company
LLCs are designed to combine the liability insulation of a corporation with tax treatment like a partnership. What happens to income is similar to what I described for S-corporations, but LLCs have extra advantages. For example, S-corporations cannot deduct the cost of insurance premiums for health, life and disability insurance or medical care for owners of the business. LLCs can, providing a valuable tax break.
If the doctor’s wife stops working in the business and the marriage is rock solid, the LLC can also provide some asset protection. This is priceless if someone files a lawsuit against the doctor.
The way liability protection works with LLCs is not the same as with corporations. Incorporation is supposed to insulate owners from liability, but small oversights in running the corporation or small details in a situation can allow a plaintiff to “pierce the corporate veil” and put the owners’ other assets at risk. When set up carefully, the LLC can protect personal assets better, with less likelihood of making a mistake that shatters the protection.
This is why I thought LLC would fit the doctor better than incorporation. He wants to stay focused on patient care. LLCs keep asset protection and tax features intact more easily.
The LLC would be set up with the doctor as the managing member. That gives him all the liability for the business. His wife would be a limited member. These roles and their liability traits are similar to limited partnerships, an older business structure of operating partners and limited partners that was not considered in this case. Limited members are not allowed to perform work in the business and have no liability for the business.
Control of the business would be entirely the doctor’s. His wife would never do anything in the business. The doctor would own just a small percentage of the business, and his wife would own nearly all of it. (This is why he should only choose the LLC if he has absolute trust in his marriage.)
If somebody won a malicious lawsuit, they could only pursue the small portion that the doctor owns, because all the liability belongs to the managing member(s). The large portion owned by his wife would be untouchable because she would have zero legal liability for the business – since limited members do no work in the business, they are not liable for actions of the business.
Some people believe this is only a dodge to evade responsibility. The reason for doing it is not to deny justice to someone who has a legitimate complaint–the doctor’s malpractice insurance should take care of legitimate claimants. The reason for asset protection is to guard against malicious lawsuits, which become more common in a bad economic climate, and to protect his wife from financial ruin because of something in which she had no hand.
In case you think losing it all could never happen to you, I am personally acquainted with a few former landlords who lost their entire real estate portfolios because they operated as sole proprietors. They had no asset protection. Each of them lost a lawsuit filed by a tenant about one building, and the court judgement took all their buildings. I also once lived in the same apartment building as a woman who supplemented her income by repeatedly staging slip-and-fall accidents, for which she always accepted out-of-court insurance settlements, until someone tipped off the authorities. Such people really are out there!
There are additional steps this couple can take for asset protection if they own a lot (say, $500,000 or more) of other assets outside the business. That would involve forming at least a separate limited partnership or separate LLC in the same manner as I described for the active business LLC, and transferring assets into it. Ownership and control would be divided in the same manner used for putting the doctor’s medical practice into LLC form. The idea behind doing that is to protect most of the assets from lawsuits that might be filed in a personal context because someone believes the doctor is rich. For example, this would protect the doctor’s home and bank accounts against the slip-and-fall con artist if she staged one of her falls at his home.
In this case study, limited partnership was stricken from the list before we began, so the case study does not compare all available business forms. We also did not consider trusts or foundations, which are appropriate for some people with high net worth. Even if you think you learned enough here to decide what business form you should use, you should still talk it over with a professional because I have only touched upon high points, not all the many pitfalls and nuances of each business form I mentioned.
In the event that you have a complex tax situation or you want to include especially strong asset protection, I suggest consulting a “tax attorney.” That is the most direct way to get both the legal and financial angles dealt with neatly, and attorney-client privilege applies.