Right now everyone who reads this article in the United States owns a business. It may only exist in potential form, but it exists. Say someone walks up to you on the street with a 555 timer and a wad of cash. He pays you to make an astable oscillator on the spot. Congratulations! You, Mr. Business Owner, now have business income. And if you still need convincing, the IRS will happily remind you that you are a business owner by requiring you to pay 15.3 percent in social insurance taxes instead of the 7.65 percent you used to pay before you were employee and employer, on top of requiring quarterly estimated tax payments on your revenue.
But being a sole proprietor carries its own set of risks—chief among them being that there is no legal veil separating your business assets from your personal life.
Let's take an example. Imagine your hypothetical client takes the 555 circuit you created earlier and finds a way to hurt himself with it. He can take you to court for building it wrong, or not training him on it, or any other reason that his lawyer can conjure up. As a sole proprietor, you are personally responsible for the work that you completed. Blame must be assigned somewhere, and you personally created the circuit so you may personally be liable. That means that your client can target your personal bank accounts, your house, your car, your amazing lab equipment, and any other personal assets you own.
This personal liability would deter many of us from ever taking work, but luckily there are other ways you can set up your business which offer increased protection from liability. Here’s a quick rundown of some of the different types of business entities available in the United States:
Limited Liability Company (LLC): This is basically the same thing as the sole proprietorship for taxation purposes, which means if your company makes $100k this year, it is the same as if you made $100k this year. That incomes passes through to you, personally—and is taxed at your personal tax rate. But it offers more protection than the sole proprietorship we sketched above. If your client sues you, she or he is limited to your business assets, not your personal assets. LLCs can be a good choice for engineering consultants, and it’s also nice that there are no filing requirements. Even paying your taxes is easy, since it’s all done on your personal tax return. This is the simplest way to get started.
C-Corporation: C-corps are what many of us think of when we picture a corporation. You can parcel-out ownership among many people by giving them shares in the company. You pay taxes according to corporate tax rates instead of having all your earnings flow through to your personal income. You also have a very strong separation between your personal and business assets—provided you don’t intermingle them. You’ll need to file a form every year, choose which state to incorporate in, and file business taxes separately from your personal taxes.
S-Corporation: This business structure lies between LLC and C-corps. It offers most of the liability protection available to C-corps, but the income you earn flows through to the owners’ personal earnings (and tax rates) like an LLC. It also limits the number of people who can own the company to 100, unlike a C-corp. The IRS places additional restrictions on who can set up a S-Corp.
Once you identify the kind of business structure that makes sense for you, you’ll need to take care of a couple of additional steps.
Register the business name with your state (usually a 5-minute form and about $100).
I can't help you much with this step, since each state is different. But you basically just have to pick a name, a purpose, and an address where they can find you if they want to cause trouble. The good news is that saying your purpose is 'Any legal purpose' is just fine. This step is remarkably easy.
Get an Employer Identification Number (EIN) from the IRS.
The IRS likes to see how money flows, so you'll need to get an ID number which acts as your company's social security number. When you fill out tax forms or open a bank account, this is the number to use. This is an online form that takes just a few minutes to fill out.
Some rules to pay attention to:
- The company has to be the entity that is named in all contracts. Do not put your personal name, and when signing be sure to list your title and company name.
- All finances must be kept separate. Don't let a client pay you personally, and then reimburse the company for the revenue. Only accept checks made out to your company. Never use company funds to buy personal things, even if you're at the beer store and only have your company debit card on you. Ignore this and you could risk losing the limited liability offered by the structures above.
- Purchases can be made with your personal card and reimbursed by the company, but it has to be documented with receipts and some expense record.
- If any of these rules are found to be broken, it could ruin your entire corporate protection, so don't mess it up! When in doubt, ask yourself if the financial maneuver you're considering would be a good idea if you weren't the one running the company.
- While your personal liability is protected by the corporation, the liability still exists and lies with the company. Lawsuits can still cause many problems and put you out of business, so be sure to keep your nose clean.
These are just a few pointers that should encourage you to start evaluating which business structure makes sense for you. A wealth of information exists on the IRS website where you can learn more. And remember, using a 7-11 parking lot to find clients is probably not a winning strategy.
Author’s note: I’m not a lawyer, I’m just a guy. These thoughts are based solely on my personal experience and do not constitute legal advice. When in doubt, seek out qualified legal counsel!
James Benson is writing a series on 'Engineers As Consultants' to educate and encourage salaried engineers to consider if hanging a shingle is right for them. New posts on the first Monday of every month.