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Sole proprietor, LLC, or S corp: Which structure is right for your IT business?

When you own a small IT business, your focus is usually on your work and on your clients. However, it's worth taking time to consider what kind of legal structure you need and whether your needs will change as your business grows.

Flying solo: The sole proprietor

According to FindLaw, many people who work for themselves don’t even realize they’re sole proprietors. This could be partly because you don’t have to file any special paperwork with your state to gain sole proprietor status. Basically, any time you perform “work for hire” (meaning you get a 1099 instead of a W2 at tax time), you’re a sole proprietor in the eyes of the IRS.

So heads up: if you’re running an IT business by yourself, you’re probably a sole proprietor.

Sole proprietorships are known as “pass-through” entities. This means all business income goes straight to you, the business owner, and you then report profits, losses, and business expenses on your individual tax return. This cuts down on paperwork and lets you pay taxes as an individual rather than as a corporation, which can often save you money. Legally, it also means that you and your business are considered one and the same.

Liability is probably the biggest drawback to a sole proprietorship. Since there is no legal line drawn between the assets of the owner and the business, collectors can come after your personal income and property if there are any losses or debts. If a lawsuit is involved, the stakes can get even higher.

While IT is a relatively low-risk field overall (compared to, say, construction), all businesses face some risk. It’s important to be aware of the liability you take on as a sole proprietor.

Reduce your risk with a limited liability company

A limited liability company (LLC) is a slightly more complicated structure than a sole proprietorship – you need to file paperwork and pay fees to get it up and running. However, the paperwork is usually pretty straightforward and the fees are often a few hundred dollars or less, depending on where you live (do a state-specific search for more details).

Another major benefit, according to Nolo, is that an LLC separates the liability for the business from you, the owner. This means your assets are kept separate, so if your business is facing debt collectors or a legal judgment, your personal assets are protected and can’t be seized to pay off your business debts. LLCs are also “pass-through” entities, so you report any income and expenses from the business on your personal income tax return.

“I recommend the LLC for most companies and clients, simply because it has the best tax treatment,” says Bob Zeglarski, founder of Cutwater Law, PLLC. “It’s treated as a partnership, so you are only taxed once, unlike a corporation, where the entity is taxed, and then a shareholder is taxed on any dividends. The other advantage of an LLC is that you have the same liability protection that you would have with a corporation. So the LLC is really the best of both worlds, both the liability protection of a C corporation, but the tax treatment of a partnership.”

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Moving on up to an S corporation

The S corporation, also known as an S corp, is another popular choice for small businesses. For one, it provides certain tax advantages. If your business is an S corp, you pay yourself – and any employees – a salary, and you can deduct payroll expenses, such as federal and state taxes and FICA-required contributions. Any profits left over can be distributed to the owner(s) as dividends, which the government taxes, but at a lower rate than it does regular income.

“Hold up,” you may be thinking. “Isn’t that double tax? That doesn’t sound like such a good deal.” S corps can avoid double taxation by allowing only one tax report to be filed from personal shareholders of the business.

The S corp also has some downsides for small IT business owners. For one, it costs more to set up. There is also more paperwork, and there are stricter guidelines you must stick to, or risk losing your S corp status. “I usually recommend an S corp to somebody who has a small business that won’t have a lot of owners, be taking on investments down the road, and really be growing very much,” says Zeglarski. “An S corp could be a good fit for a small business that is planned to be operated as a family business, because you get partnership tax treatment just like an LLC, but also get the same liability protection as a C corporation.”

Limit your liability exposure with IT insurance

No matter which structure you choose, one way to limit your risk exposure is by purchasing new business insurance, especially IT insurance. Popular sole proprietorship insurance options for IT business owners include independent contractor liability insurance and a business owner’s policy (BOP), which combines general liability insurance with commercial property insurance.

Another beneficial choice for IT businesses of any size is errors and omissions insurance (E&O). A technology E&O insurance policy can help cover the cost of a lawsuit if you make a mistake in a line of code, miss a deadline, or deliver a finished product that doesn't meet your client's standards.

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