2 months ago · 4 minute read
One of my mentors had a rule-of-thumb that if an entity was doing more than $30,000 per year on a consistent basis, then it was worth the cost of incorporation.
In his mind, until a business reached that point, it was better to stay unincorporated and just buy insurance, and keep things simple. No entity. No extra tax filings. No hassles.
Based on the question, at $30,000 you are on the margin where my mentor would have said to incorporate. But, there might be one more factor that will tip the scales toward incorporation.
There’s a lot that goes into making a decision to incorporate. If you are running a small side gig that makes a few hundred dollars per month, it may not make sense. But, once your business is making a steady income, then the benefits add up, and it is probably worth the cost.
As a rule, it is wise to form a corporation or LLC to run a company, even if it only has one owner.
However, given the limitations discussed below, the owner should first weigh the costs and benefits of incorporation.
Forming a corporation has a cost of formation, a cost of annual filing, a cost for state taxes, and a cost for filing annual tax returns. This cost might easily be $2,000 per year.
Is it worth the $2,000 per year in cost in order to gain the benefit of partial limited liability? In my opinion, it depends on how much the company makes.
Does Your Side Gig Involve Contracts with 3rd Parties?
Are you doing contract work for third-parties? If so, then having a corporate entity will make it easier on those relationships. The hiring company will not have any hesitation over employment laws; they will not be required to hold “backup withholding” for the IRS, and they may not even need to send you a 1099. If you are an individual, then the entities that hire you may have hesitation over these things.
If a company makes a sufficient income to justify the expense, then you should incorporate. If not, then you can probably gain almost as much protection by simply staying a sole proprietorship and buying a commercial general liability policy.
The Standard “Business Owner’s Policy” Insurance
One of my corporate entities has a “Business Owner’s Policy” from The Hartford that costs about $800 per year and has a $1 million limit.
Even if you incorporate, you may want to buy a policy like this. If you don’t incorporate and want to gain some protection for the business, then a simple insurance policy may be a great solution.
I’m One Person – What About Limited Liability?
Should a one-person business incorporate as a means of avoiding liability? The answer depends on several factors.
First, a company cannot avoid liability by simply incorporating.
The owner of a corporation may still have personal liability if a litigant can “pierce the corporate veil.” This can happen when the company has no assets or insurance. If you run a corporate entity without any assets or insurance, then the law will let others get to your personal assets. The idea is that you can’t form a corporation to hide behind unless that entity has either insurance or assets to satisfy those who you might harm.
Second, a corporate entity may relieve an owner of liability, but it does not necessarily relieve officers of the company. For example, copyright infringement committed by a corporation can create liability for officers and directors of the entity.
The owners would be insulated, but the officers who run the company would not. This means that a corporate entity would not always protect the owner because his role as manager or officer of the company still leaves him in a position of liability.
Want the Legal Nitty Gritty?
In order to truly answer the question of this article, you need a quick lesson in corporate law. Why do corporations exist? They exist to provide two things: 1.) a way to have multiple owners of a venture; and 2.) a way for the owners to have limited liability.
A corporation provides for multiple owners because without a corporate entity, all businesses with more than one owner would be a partnership. Partnerships are complicated. Partners each have a say-so in the management of the business. Each partner can create obligations of the company. What is unique about corporate entities is that they provide a way to have owners who share ownership, but do not share in management of the company. The owners are limited to ownership of a share of the company, but not necessarily involved in management. Thus, as part of the feature that provides a means for multiple owners, corporations also provide a form that separates ownership from management.
A corporation provides for limited liability of corporate owners by allowing an owner to only lose what the owner invests in the entity. If you buy Apple stock and Apple fails, you only lose your stock, you don’t owe the creditors. If Apple gets sued, you can only lose your stock, not be sued for Apple’s activities. If you were an owner in a “partnership” rather than a corporate entity, then you would be personally liable for these things, and so would your other partners. You are all jointly and severally liable for the partnership’s activities, losses, legal risks, etc.
When it comes to a one-owner business, should you form a corporate entity?
You don’t need the first part of corporate law, because you don’t have multiple owners. You also don’t have management that is separate from owners. It is just you. You own it all. And, you run it all. So, you don’t need to incorporate the way you would if you had other owners involved in your business.