Many IT businesses start as sole proprietorships because that’s the default structure created when a person starts offering services on a freelance basis. When you file those 1099 forms at tax time, the IRS considers you a sole proprietor.
But at some point, IT professionals realize that they have to think about the legal structure of their business. It might happen after a conversation with a lawyer at a party or after reading an article online about incorporation. It might come after a talk with your accountant. Whenever it happens, it’s an important question to consider: which legal structure should you choose for your business?
Like most things, the answer depends on the specifics of your business. But there are some general rules that can help demystify the process of making it legal. Here’s a look at what some experts on the matter have to say.
Think about the Future
Galia Aharoni, an attorney with HG Business Law, LLP, recommends choosing a legal structure that will suit the long-term goals of the business. Specifically, she suggests considering…
- Potential liability: Sole proprietorships are “pass-through” entities, meaning that all liability, profit, and loss goes directly to the business owner. “For low-risk businesses, this is less of an issue,” said Aharoni, “as the likelihood of someone getting hurt or suing is much lower.” In other words, if you’re programming rather than creating metal machinery, a sole proprietorship might be a reasonable structure.
- Number of owners: Aharoni acknowledges that “the more owners, the more complex the company will end up being.” But if you want to go into business with a partner, giving yourselves equal ownership (through a partnership, for example) may be the most logical option.
- The stock option: If you have plans to grow your business into a publicly traded company, you have to form a corporation. Because corporations are complex to form and maintain, Aharoni suggests being very clear about why you want stock. If the reasons are muddy, a simpler structure might make more sense.
- Tax consequences: Of course, every structure comes with tax considerations. Aharoni notes that all business owners should talk with a tax professional about these before making a decision.
Consider the Venture Capital Option
When the media discuss IT startups, it usually involves the glamorous-sounding world of venture capital and exponential growth. For more than 99 percent of businesses, however, VC is simply not part of the picture. But if you are in the minority of IT startups that want to pursue venture capital as a means of funding, you must form a corporation, says Shushan Barsegyan, a Los Angeles-based business attorney with Full Circle Business Law.
Barsegyan also emphasizes the importance of consulting with legal and financial advisors before making a decision on business structure. “First,” she says, “we look at [the business’s] financial situation. How much revenue are they generating or expecting to generate in the future? While LLCs may offer more flexibility in many ways, they are also subject to an additional tax in California if the business has gross receipts of $250,000 or more.”
Of course, those laws are different in every state, and that’s precisely why it’s a good idea to check in with someone familiar with them. Spending a couple hundred dollars on a legal consultation now could save thousands in tax bills in the coming years.
Remember: Sole Proprietorship Is a Valid Choice
As part of making an IT startup more official (say, making the move from moonlighting to consulting full-time), many business owners think they have to choose a “real” legal structure – something other than the default sole proprietorship they’ve been filing taxes as.
But Skylar Bader, a startup attorney of Rockaway Park, NY-based YourStartupLawyer.Com, likes to remind business owners that remaining a sole proprietor is also an option. “People forget that sole proprietorship is a business structure, too!” she says. “It’s the easiest to start, maintain, and file taxes for.”
Bader acknowledges that the idea of unlimited liability can be terrifying. “But in many cases,” she says, “insurance is all the protection you need. You’ll have to buy that insurance for your business if you become an LLC or a corporation or whatever, if you don’t want your business to go bankrupt. So why not skip incorporating and just buy the insurance alone?”
She notes, too, that the mindset that a business has to incorporate is a relic of an older time. “[When] you rent a building and hire employees, insurance isn’t enough protection,” she acknowledges. Plus, she adds, lawyers may favor incorporation in part because it means more work for lawyers. In a traditional field like law, there’s often little motivation to change the way things have always been done, even when clients can benefit from change. But for home-based one-person businesses in the 21st century, sole proprietorship can be a useful and productive business structure.
Bottom Line: Talk with a Lawyer before Choosing a Business Structure
It may not exactly be breaking news that you should consult with a legal professional before making one of them most important legal decisions of your career, but it bears repeating. Everyone’s situation is different, tax laws are different all around the country, and there are always extenuating circumstances. Even if you don’t have this conversation right away, make time to discuss your structure with an attorney so you can be confident that you’re operating in the most financially sound way, with the fewest liabilities possible.