Tax Audit Risk Among Reasons to Incorporate Side Business

CPA Michael Hanley, who specializes in working with small business, advises:

"The #1 most overlooked tip by people running side businesses is that they fail to setup a business entity because they still view their business as a little side business that they will incorporate when things take off."

Sole Proprietorships (the business structure you default to if you fail to setup a Corporation, LLC, etc) are subject to the highest audit risk out of all the business structures. The reason for this high audit risk is that all Sole Proprietorships report their business income and expenses on Schedule C (the second most highly audited form that you can attach to your tax return). By setting up an S Corporation, you become nine times less likely to be selected for a random IRS audit (audit risk decreases from 2.7% to .3%, making it very possible that you can go your entire life without ever being selected for an audit).

Setting up a Side Business Can Be Risky Unless You Do it Right, Mithcell York, About.com: Enterepreneurs

How to Avoid an IRS Tax Audit: Incorporate Your Small Business

One tip for Dodging a Tax Audit, per the Wall Street Journal's reporting: Incorporate. The WSJ reports that the IRS continues to target Schedule C filers for tax audits and additionally notes that the IRS will sometimes act on an anoymous tip regarding a taxpayer's non-compliance with U.S. tax law.

[T]he overall audit rate this year is likely to remain about the same as last year, says Linda Stiff, IRS deputy commissioner for services and enforcement. But officials are likely to continue their emphasis on high-income taxpayers. Your chances of getting audited are especially high if you work for yourself, file what's known as a Schedule C form for sole proprietors and deal in large amounts of cash. IRS research has shown especially large amounts of noncompliance among this group.

"Like Willie Sutton said about banks, the IRS is looking at high-income, self-employed Schedule C filers because that's where the money is," says Martin Laffer, a certified public accountant at Laffer & Gottlieb in Beverly Hills, Calif. For example, he says one of his clients being audited owns several retail stores and also is a consultant.

See also:

Time to Incorporate?
California incorporation

Online Incorporation Services Review

Mark Stafford's review of online incorporation services, reprinted with permission:

Thinking about incorporating? DON'T waste your time with those online companies that claim to incorporate you. Unless of course you just have a bunch of money laying around. I am sharing this with you because of the lesson I learned the hard way.

I'll start by saying I know pretty much nothing about business when it comes down to all of the legal issues, tax, and accounting mubo jumbo and so forth. I like to just
concentrate on doing the work at hand. For example, if you mow lawns, then you should do just that. Why should you have to have a business degree, learn to be a tax whiz, and be a legal expert right? While all of these are great occupations, and their great to know about, if you mow lawns, then that would really put you out of a lot of time and energy, when you could concentrate on getting accounts and getting the work done.

I made the mistake of starting a business jumping in head first, and with the best intentions of course, but I ended up in a mess. I fell into the hype of all of those
"incorporate now" websites, and I'm not mentioning names (there are a ton of them), as they seem to all be very similar.

Most of them will ask you if you would like to incorporate, what type of corporation package would you like- as if you were ordering at a drive- thru. They are not
allowed to and won't give you any sort of legal advice, as they just sell the "package." It's really up to you to do ALL of the homework and research about the LLC's, S corps, C-corps, etc. They will in most cases be your "registered
agent," in which you will be represented in the event you are sued. And they will send you a VERY nice notebook with stock certificates and numerous other forms. In my case I got that and a nice library of five books (you would have to
be a lawyer to understand them), which if you were not already confused - you get the picture.

Ah, then the price. This can be from $600 and up. This is when I found a lawyer to be the best way in the first place, as they will know what type of corporation would best suit you. (No pun intended). In my case I had purchased the wrong type of corporation, and my lawyer had to fix it. In the end he charged me $400 to undo one corporation, and fix me up with the right corporation. AND he was also my registered agent. He also informed me that if you really wanted to put in the time, you could do the whole thing online in most cases for about $75. Wow.

Here in higher-cost California, the costs payable to state government of a properly done incorporation are a minimum of $150 - something to keep in mind when certain paralegal services on craigslist and elsewhere offer the entire package, including their 'service', for $125!

See also:

Online incorporation review article

Business Licenses and Online Incorporation Services

I recently received an email notification announcing a new service offered by a popular online incorporation and document filing service. For $75, they will email you the appropriate business license forms for you to complete and file. While this information may be helpful to some new business owners in locating the appropriate regulatory agencies and their respective forms, my flat fee full service incorporation and LLC formation packages have included this service for years (except that we complete the forms for you and when possible, file them for you on your behalf, and answer any questions you may have about the filings before and after they are made). Unforunately, it is hidden fees and add-ons like these that make online incorporation services much less of a bargain than they might initially appear to be.

FAQ: How much to form a corporation? Review a contract? Draft a living trust?

As an attorney, I am frequently asked by potential clients some variation of the following question:

How much to form a corporation, to review this contract, or to draft a living trust?

Usually, the honest answer is, it depends (although this tends not to be what the questioner wanted to hear). Legal services are professional services more akin to those offered by doctors or even automobile mechanics than to purchasing a fungible item like a television. With a TV, you know what you're getting before you buy, and you can price shop amongst competitors, because you know the product is going to be the same regardless of where it is purchased. Conversely, when you visit the doctor, you know you need a check-up or aren't feeling well, but until you get in there and the physician runs some tests, you aren't going to know how much it will cost. Asking an attorney, 'How much to fix X problem?' is often times akin to asking a doctor, 'How much to make me better?' or your mechanic, 'How much to fix my car?' You could ask what a doctor's visit costs, but one doctor's visit may not cure you. Likewise, you can ask me about my flat rate incorporations, but you may also need contract, employment, trademark, or other legal work, and in fact, a corporation may not be the best entity for you, so the number quoted must be put into context.

For contract negotiation, drafting, review, and counsel, my rates are hourly, and the final fee will depend on a host of factors. The fact that an agreement to be reviewed is five pages long is only one of these factors; the others will remain unknown until you sign on with me and I actually dig into the issues. (Just as your mechanic won't be able to determine what labor and parts are needed to repair your vehicle until you have paid him to look under the hood.)

Further, clients may not realize what they need. The question, 'How much for a living trust?' ignores that a living trust may not be needed at all, one living trust alone may not be sufficient, and that proper estate planning involves more than just drafting a revocable living trust (and even that is customized for each client's needs).

In summary, just as with the doctor and mechanic, some small leap of faith is required of the potential client. You must hire an attorney to analyze your circumstances and advise you; the component parts of the solution may have flat fees knowable in advance, but some legal work may additionally be recommended or even required to get where you want to go. After all, part of what you are hiring the lawyer to do is identify legal issues of which you might not be aware. Seen in this light, calling around to attorneys to compare prices for an LLC or a trust may give you an idea of the fee level, but the answers will rarely be precise, and others questions may be at least as useful. As a last resort, of course, you can always take your legal business elsewhere if your first choice for an attorney proves unsatisfactory, or you feel you are being overbilled.

California LLC Quotes in Today's Los Angeles Times:

LLCs provide key financial benefits:
The owners receive tax and liability advantages. Such registrations have risen, but the format is not for everyone.
Cyndia Zwahlen: Small Business Report
July 25, 2007

To be an LLC or not to be an LLC? That is the question for a growing number of small businesses.

Whether to adopt the relatively new limited liability company format or to set up under the more traditional form of a corporation, partnership or sole proprietorship is a key decision for a small-business owner.

"An LLC is an important option for small businesses," said Jonas M. Grant, a business attorney based in Burbank. Interest in the format is high, he said.

The benefits of an LLC seem almost too good to be true.

The owners, or members, have the personal liability protection that shareholders of a corporation do, with far less paperwork and fewer regulations.

That means — barring illegal, unethical or irresponsible activity — their personal assets are not on the line when it comes to covering the company's business debts or legal claims against it.

At the same time, the owners avoid the double taxation on profit to which shareholders in a regular corporation face.

Limited liability companies pass profits to the members, who pay taxes at their individual income rates, as in a legal partnership. In California, where this type of company has been legal since 1994, there are 409,619 limited liability companies, according to the secretary of state's office.

The number of companies registered under this format has jumped each year since 2000, when the state finally allowed limited liability companies to be set up by single-person businesses. More than 73,000 LLCs registered with the state last year, compared with about 31,000 in 2000, the secretary of state's office said.

That growth doesn't surprise LLC expert Anthony "Tony" Mancuso, a Berkeley attorney who wrote the new edition of "Nolo's Quick LLC: All You Need to Know About Limited Liability Companies" (Nolo, 2007). "It was obvious to me that LLCs would become the next big thing in business entities because of the combination of benefits," said Mancuso, who has written several books on limited liability companies and other corporate structures for Nolo, a self-help legal publishing house based in Berkeley.

The newest version of his "Quick LLC" book lays out the basic features of limited liability companies, explains important exceptions to owners' limited liability and compares the LLC with other business formats.

He also discusses converting an existing business to an LLC, as well as tax and management issues. And he devotes a chapter to the paperwork involved in setting up a limited liability company. There is also a sample operating agreement and a checklist to help you determine whether forming an LLC makes sense for your business.

Considerations include whether your type of business is one in which business debts and claims could threaten your personal assets. Another consideration is whether you have assets, such as equity in a house, that could be at risk without the protection of an LLC.

"Anyone a little bit nervous about the adequacy of their insurance coverage" could be a good candidate, Mancuso said.

Existing sole proprietorships or general partnerships and anyone thinking of forming an S corporation, an entity that generally pays no taxes, he writes, could benefit.

Those who aren't good candidates include existing regular corporations, also known as C corporations. And in California, some professionals such as lawyers and architects may not form an LLC.

If you want to raise money from venture capitalists or by selling stock, an LLC probably is not the business form you need.

Mancuso makes it clear that despite the potential benefits of an LLC, they have to be weighed against the cost, especially in California. Although it costs just $70 and takes a one-page form to set up a limited liability company in California, ongoing annual fees and taxes could cost more than 10 times that amount. There is a minimum annual tax of $800, payable to the state Franchise Tax Board.

And once gross receipts hit $250,000, additional annual fees kick in, which range from $900 to $11,790.

There have been several challenges to the constitutionality of the state's LLC fees, but the issue is still working its way through the courts.

Although Wyoming, in 1977, was the first state to authorize limited liability companies, it wasn't until 1997 when helpful new Internal Revenue Service rules kicked in that the format began to gather steam among business owners

Limited personal liability protection does not apply if you personally guarantee a business debt or bank loan for the company. Then your personal assets are on the line. That will probably happen more often when a company is young and has not yet established its credit history.

And as is the case with all other business entities, an owner can be held personally responsible for financial losses caused by their negligent or careless actions, Mancuso said.

Mancuso recommends three steps to safeguard the protection against personal liability offered by an LLC.

Act fairly and legally, including disclosing important facts or financial information to members or outsiders such as vendors.

Put enough money into the LLC to properly fund it. Otherwise, a court may not consider it a legitimate business and yank the personal liability protection.

Separate personal expenses from LLC expenses. Aside from making good business sense, that is another way to show that the company is legitimate, especially if you will be a single-member LLC.

The limited liability format isn't available or appropriate for some business entities. In addition to a number of professions, banks, insurance companies and other financial service firms are not usually candidates for a limited liability company.

Even if you qualify for an LLC, you may not need the protection. In his book, Mancuso gives an example of a freelance proofreader working from home as a business that may not need the extra protection from lawsuit claims and business debt.

And if you decide to end your California limited liability company, it must be formally dissolved. For more details, go to the California secretary of state website at http://www.sos.ca.gov/business/llc/llc_faq.htm or call its business programs division at (916) 657-5448.

Important tax information for California limited liability companies can be found in the Franchise Tax Board's Form 3556, available online at http://www.ftb.ca.gov . Just type "Form 3556" in the search box.

Armed with the facts, you can decide whether LLCs have real benefits or not.

"Sometimes I get a new client who tends to believe an LLC is manna from heaven," Grant said. Of course that's not always the case, although, he said, "it certainly has its place and should always be considered."

(C) 2007 Los Angeles Times

Online Incorporation Services Review Article

I recently published an article that reviews the pros and cons of online incorporation services and other non-attorney corporation and llc formation options:

http://ezinearticles.com/?Online-Incorporation-and-LLC-Formation-Services-Advantages-and-Disadvantages,-Pros-and-Cons&id=628630

I don't expect this to be too popular with either the online incorporation services, or with the general public, because the article doesn't say what people want to hear ('quick', 'easy', 'do it yourself', 'save money', 'no lawyers', etc.), but I see the results of not using an attorney to protect one's self and do things properly the first time on an almost daily basis.

Just today, for example, a potential client called me to discuss representation and after a short initial consultation, agreed that a legal mess she was currently in that was likely to cost her $100,000 in losses could have been greatly reduced or, more likely, avoided entirely, with $2,000 - 5,000 worth of legal planning.

Many of my comments and opinions on online incorporation services also apply to storefront legal assistance clinics, paralegal and document preparation services, and accountants. Clients who have used these services to incorporate a corporation or form an LLC before they began working with me often show me corporate books with missing or inappropriate documentation, odd organization, wrong entity used, and the like. An accountant using a form is not giving you state of the art, custom documents; an accountant attempting to modify or draft legal documents is engaged in the unauthorized practice of law (UAL), a misdemeanor in California.

See also:

Is Legal Zoom a Good Idea? Do the Documents Work? by fellow WealthCounsel estate planning attorney Alexis Martin Neely;

LegalZoom.com reviews; and

Online incorporation service review.

[This post updated August 2008.]

FAQ: Advantages & Disadvantages of Online Business Incorporation Services

On a legal message board on which I respond to user's questions with user name Calif Business Lawyer from time to time, a question concerning online business incorporation was posted, to which I responded, and which I'm reprinting here, because I get frequent questions about the advantages and disadvantages of online incorporation services:

I am using an online service to create the S-corporation, and one question asked by the website is to check off a box if it is a "personal service corporation". Examples of such corporations are health and attorney industries, etc. I don't know if a beauty salon is classified as such.

It's probably not critical to classify the corporation as a personal service corporation except when filing taxes, right?

My reply:

Unfortunately, this illustrates one of the problems of using online incorporation services - if you don't know the answers to the question being asked (which in this case doesn't make a lot of sense anyway - only a C corporation need be concerned with personal service corporation [PSC] classification), you need to obtain legal and/or tax (accounting) advice prior to or in conjunction with - or instead of - incorporating online. Of course, by the time you pay to consult an attorney and/or accountant, then pay the document preparation services, most or all savings will have evaporated. Also, such services don't usually start from square one, and ask you, Are you forming in the right state? Have you considered an LLC instead of a corporation (or vice versa)? Why or why not?

Most of the online incorporation services include disclaimers like this one I found in small print at the bottom of one popular site:

"[Company] is not a law firm and is not a substitute for the advice of an attorney."

And this on another leading site: "[We] cannot provide information as to whether a person should incorporate or form a limited liability company or a partnership. If you are contemplating forming any of these entities you should consult with private counsel regarding your individual fact situation."

For those who know exactly what they want, and can explain it to someone else in plain English in a few sentences, the disadvantages of online incorporation services may be overcome by the one big advantage of cost savings. In my experience, however, this is a minority of those who are using such services. And savings up-front sometimes ends up in more expenses later, when I am hired to resolve business disputes the corporation bylaws and LLC operating agreements should have covered, or would have covered, had they ever been adopted, or to dissolve or merge entities, and replace them with better-suited ones.

You are correct that the personal service classification is largely tax-related. Some regulated professions are prohibited from forming certain types of business entities in some states (e.g., California does not permit professional LLCs - to test out your favorite online incorporation service, try starting the process of forming a California professional LLC online, and see if the system warns you or rejects it before you get to the submit order stage).

Don't forget state and local licensing and registration requirements.

Personal service corporation defined:

"A type of C-Corporation that is owned and operated by individuals performing personal services in such fields as health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.

The requirements for a PSC are:

The corporation is a C-Corporation.
The corporation's principal activity during the year is the performance of personal services.
The personal services are primarily performed by the employee-owners of the corporation.
Employee-owners own at least 10% of the corporation's stock.

PSC's must generally use a calendar year as their fiscal year and are taxed at a flat rate of 35% on all of their taxable income."

See also:

Zoom Past Legal Zoom and
LegalZoom - Why We Love It

2007: Time to Incorporate Your Sole Proprietorship?

IRS to Target Schedule C Filers:

In a recent telephone conference, IRS commissioner Mark Everson said that they will be conducting more audits on individuals running unincorporated businesses (i.e. self-employed individuals).

While Schedule C filers have long been audit targets for the IRS, they are now stepping up their audit efforts because they believe that self-employed individuals represent a large portion of those individual taxpayers underreporting their income.

IRS to Target Schedule C Filers, About.com U.S. Business Law / Taxes, 25 December 2006

Incorporating, while not a panacea by any means, nor appropriate for all small businesses, entrepreneurs, and those with side businesses in addition to W-2 income, can help reduce exposure to a time-consuming audit, as well as potentially offering tax, asset protection, and other benefits to business owners.

See also: January 2009 update

New Year, New Look at Your Business Entity

With a new year comes a good time to reevaluate your business entity (or lack thereof).

Business owners with an existing corporation should make sure that they have held and documented at least their annual meeting; if this hasn't been done for a while, this should be corrected as soon as possible. Ignorning this required corporate maintenance means you are failing to follow the corporate formalities and may be one step toward negating the limited liability of the corporation ("piercing the corporate veil").

Also for existing shareholders, members, officers, and directors of California corporations and limited liability companies (LLCs), required Secretary of State filings and Franchise Tax Board tax filings should be brought up to date if in arrears. If the business entity is no longer being used, and perhaps has been neglected as a result, to avoid further tax liability (which keeps accruing, whether the entity does business or not), it should be dissolved.

If a change from C corporation to S corporation tax status is being considered for a corporation, an accountant should be consulted.

For those without a current business entity, who are either starting up a new business venture, or still filing a Schedule C as a sole proprietor, it may make sense to think about the potential benefits of incorporating or forming an LLC (which, depending on the circumstances, may include limited liability, avoiding disputes with business partners, better image for clients, self-employment tax savings, and/or decreased tax audit exposure). For a free consultation by phone or email, or for assistance with the other legal issues discussed in this post, please click here.

California Secretary of State Business Entity Processing Times for Corporations, LLCs, Etc.

The California Secretary of State generally takes 3-4 weeks to process regularly filed corporation and limited liability company (LLC) formation documents, but due to the holidays and the usual heavy end-of-year and beginning-of-year filing volume, is currently operating on a 6-week plus schedule.  The backlog will likely diminish by the end of February, after the wave of new corporations formed for the beginning of the year subsides.  One can check the updated business entity processing times (and those for other filings, as well), here.

If standard processing times are inadequate, rush filing options are available; however, these must be weighed against the slightly increased legal fees and costs and substantial additional state filing fees. When possible, filing over the counter for a small additional fee in a regional office can speed turnaround time substantially. The Law Office of Jonas M. Grant PC regularly utilizes this method to speed its incorporations for clients.