When you started your business, did you prepare a written plan? Did you put your “team” of advisers in place and set your five-, 10- and 15-year goals? Most budding entrepreneurs don’t do these things. There is never any real understanding of whether things are in order, whether there is a risk right around the corner that could destroy everything or whether there is any way to exit when retirement is looming.

Within my next several articles, I will address topics that should be part of your business analysis. Through this process you will determine if you deserve an A+ or a D- on your business report card. If you are not attaining an A+, hopefully you will consult with your trusted advisers to raise your grade.

The first self-assessment step we will tackle is whether you are operating in the correct legal structure.

Should You Operate As an Entity?

There are numerous business structures under which contractors can operate, the most common being sole proprietorship, partnership, corporation (including S corporations) and limited liability company. Some states limit your options; for example, LLC is not allowed for contractors in California.

When determining which structure is appropriate for you, you must look at several issues: liability (risk), expense and formality, control and continuity (transferability) and taxation.

  • Risk: If you incur a liability that is not covered by insurance, what do you stand to lose? Your house? Your savings? If you want to protect your personal assets, you should consider operating as an entity.
  • Expense and Formality: Operating as a sole proprietor is probably the least expensive operation. There are few state filings, if any. You only need one checkbook for personal and business expenses and one tax return. With a corporation or LLC, there are annual forms, filing fees, additional tax payments and tax returns, separate bank accounts and separate business accounting. If you do not want any additional expense or hassle, an entity structure may not be right for you.
  • Control and Continuity: If you have a sole proprietorship, when you die your business ceases. If you operate as an entity, your business can continue so that it can be sold or transferred to family members. Proper setup can allow investors to participate in the financial benefits of the company without running the show.
  • Taxation: A sole proprietor reports business income on his or her individual tax return and is taxed at individual rates. A corporation pays its own tax. Without careful tax planning and a close analysis of year-end profits and cash available to pay bonuses, there is a possibility of double taxation on the profits of the business. Choosing to operate as an S corporation or an LLC can eliminate this year-end problem. There also are beneficial retirement plans for entities, which could give you additional tax deductions.

Are All Your Documents in Order?

Corporations and LLCs can be formed by filing a document with the state; however, many more documents are necessary to have a valid entity. If you formed your entity with an online service or do-it-yourself book, chances are many required documents are missing. Failure to maintain proper entity documents could jeopardize liability limitations and expose you to tax problems. Make sure you have the following in order:

  • Corporations: You must have bylaws, organizational minutes, an exemption election to make sure you are not subject to U.S. Securities and Exchange Commission regulations, stock certificates, ledgers, annual minutes, annual state filings and a tax identification number. Make sure you have shareholder and director minutes for every year you have operated under corporate form.
  • S corporations: You need all of the above documents, plus a shareholder agreement electing S corporation status and form 2553 filed with the Internal Revenue Service.
  • LLC: You must have an operating agreement and tax identification number.
  • Partnership: You need a partnership agreement and fictitious business name statement. If you are a general partnership, each partner is responsible for the liabilities of the business. Investigate operating as a corporation, LLC or limited partnership to attain maximum protection.

Take this first step in getting your business on the right track, and stay tuned for the next self-assessment step in the January 2011 issue.

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