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To the List,
I'd like to shed what I hope is a little light on this topic of
incorporation. Let me preface this with the comment that I'm not an
attorney or an accountant (nor a piano technician, for that matter, though I
am a very interested amateur). My background is in setting up and working
with start-up biotech companies, which I've done for the last ten years or
so.
As has been pointed out, the primary benefit of "incorporation" to the small
private business is for liability protection. That protection does not mean
that the business can or cannot be sued, or that in the event of a lawsuit
that the business (or its insurance carrier) must pay for its defense. It
means simply that the potential loss of the corporation is limited to the
assets of the corporation. All personal assets of the stock holders,
directors and so on are separate, and cannot be used to satisfy any judgment
against the corporation (but see below).
Let's consider the following admittedly grossly simplified situation. Say
you have picked up the only remaining original Cristofori for a careful
restoration. Once in your shop, the building, including the piano, is
consumed by fire, due presumably to the (unknown) arsonist that has plagued
your town for the last year. The owner of the piano sues to recover the
rather substantial value of that "irreplaceable" instrument. After
defending yourself in court, you are found liable for the value of the
instrument, and that value far exceeds the modest insurance you carry.
If your corporate form is that of a sole proprietor or a partnership, the
owner of the Cristofori now has the right to your (and your partner's)
personal assets to fulfill his judgment. This includes personal property,
real estate (like the home you own), cash, collectibles, investments, and so
forth. If instead your corporate form is that of a "C" corporation, only
the assets of your business can be used to fulfill the judgment. That
includes the things you transferred into the corporation initially to
purchase its stock, and assets that the company has bought or developed over
its course, like your company vehicle, tools, machines, buildings,
intellectual property, customer lists and so forth. None of your personal
assets can be used to fulfill the judgment.
Between the two extremes cited above, there are subchapter S corporations
and LLCs (Limited Liability Companies). Both of these offer substantial
liability protection, but it becomes increasingly difficult to "pierce the
corporate veil" as one moves from LLC or S Corp to C Corp. The more a
business looks like a single individual, the easier it is for an outsider to
pierce the veil and go after personal assets for tasks not sanctioned by the
company (like gross negligence). Still, the protection is substantial, and
having an S Corp or LLC may be sufficient to prevent a law suit if the
company's assets are modest.
As far as taxes go, earnings from sole proprietorships, partnerships and S
Corps (and LLCs I believe) are all taxed as ordinary income. Earnings from
C Corps are subject to a corporate tax, and any earnings passing to
shareholders ("dividends") are again taxed on the personal income tax form.
Please note that salary and bonuses are deductible expenses, so all of these
can be highly lucrative to its employees, but still show a loss for its
owners.
All S and C Corps and LLCs must register with the state, and pay a yearly
fee depending on the form. There are also modest requirements for annual
shareholder meetings, and certain requirements for the number of owners.
Whether liability protection is worthwhile for you or not, that depends on
the nature and risks of your business, the liability coverage you have (you
do carry liability insurance, don't you?), the sort of clients you have, and
your tolerance for paperwork and registration expenses. My guess is that
most of you could limit your liability through carefully drawn contracts
that you would execute with your customers, and an appropriate liability
insurance policy. I've never signed a contract with any of my piano
technicians over the years (but then most of the services have been minor),
and I don't know whether that would be off-putting to your customers or not.
If you deal with larger financial amounts, you may wish to consider an S
Corp -- they really are set up for the very purpose of liability protection,
and are transparent as far as taxes go. C Corps are set up for the big boys
(like IBM, GM and so forth), and would be useful primarily if you are
garnering substantial outside investments and are geared to a corporate
liquidity event (sale or an IPO). LLCs are very flexible, can be crafted
in almost any way you wish (more like a partnership to more like a C Corp)
but I would guess are not really necessary. My own clients usually start
out as S Corps, but once they take in the substantial outside investments
they need (millions to tens of millions of dollars) they usually are
converted into C Corps for reasons of increased accountability, liability
protection (these investors have a TON of money), liquidation preference and
loss carry-forward provisions.
One last thing to keep in mind. While everyone worries about law suits,
remember that attorneys are pure capitalists, and will get paid first. A
civil suit by a good attorney, from filing through depositions, jury
selection, expert testimony and trial, costs at least $50,000. Is your
potential adversary really willing to pay for that, win or lose? Or is the
case worth three times that for an attorney paid on contingency? Really?
I hope that the information here has been as helpful and interesting to you
as that which you share continually with me. If you are interested in
incorporation, you really should talk with an attorney, and the basic
consultation should not be that expensive (a few hundred dollars).
Frank Jahnke, Ph.D.
President, FMJ & Associates
Adjunct Professor, Chemistry and Biochemistry, Arizona State University
Auburn, CA
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