Legal Form

The Legal Form of Your Business

Note: I am not an attorney. This is not to be construed as legal advice. What follows below are basics and generalities, according to the law as it currently stands. It can change. Please consult a competent attorney in the proper field for details about your personal situation.

Your business can take one of four major forms: sole proprietorship, general partnership, limited liability company, or corporation. (S corporations will not be discussed.) A sole proprietorship is a business with only one owner. A general partnership is formed by two or more people. It takes only one person to form a corporation. And you can be its sole employee, too.

Most private studio teachers are sole proprietors.

Set-Up

A sole proprietorship (SP hereafter, to save me a lot of keystrokes) requires no filing of paperwork or payment of fees.

Your state may require a general partnership (hereafter partnership) to file and/or to pay fees. If it doesn't, I strongly advise you to see an attorney for a partnership agreement prior to starting your business. To save money, you can do it yourself with a book from Nolo Press or something similar, but you probably want to run it by a real attorney.

Beginning a corporation requires complex forms, filing fees, plus sizable attorney and accountant fees. There are also on-going paperwork and fees.

So why would any businessperson want to set up a corporation?

Liability

That's why.

With a SP or a partnership, you are subject to unlimited -personal- liability. This means that if your business goes into debt, your creditors can seize your -personal- property. If someone sues you (say a student's Uncle Festus trips on a rug and injures himself) and your insurance coverage does not meet the amount of the liability claim, your personal assets may be taken and sold to complete payment. Pretty horrifying.

A person in an incorporated business technically has security from seizure of his personal assets. Only corporate assets may be attached to satisfy the claim. I said "technically" because this security - - called the "corporate veil" - - is being "pierced" more and more often, so don't opt for a corporate set-up because you think it offers 100% protection for your personal assets.

Now let me backtrack a bit to a limited liability company. It is a cross between a partnership and a corporation, offering the personal asset protection of a corporation but the flexibility of a partnership. These are fairly new legal entities, and if you are considering one of these as an alternative to a partnership, you definitely need to research the specific laws of your state. I will not discuss the LLC further here.

If you are a one-teacher operation, your options would be a SP or a corporation.

If you are in business with some other teachers, any of these legal forms would be a possibility, depending on whether the other teachers are your employees or not.

Taxes

In a SP, profits are taxed at the personal income rate. Same for a partnership. Profits of a corporation are taxed at the corporate rate, which is usually lower.

Losses

If you operate as a SP or partnership, any losses may be used to offset previous years' profits. This can mean an immediate tax refund. If you are a corporation, losses must be carried over to the next tax year.

FICA and Medicare Taxes

As a SP or a partnership, you must pay 100% of these taxes. In a corporation, these taxes are shared by the corporation and the employee (if you are the sole employee of your corporation, part is paid with "corporate" money and part "taken out of your paycheck").

Unemployment Taxes

You owe no unemployment taxes if you are a SP or partnership. If you are a corporation, 100% of these taxes must be paid by the corporation.

Salaries

Only employees' salaries are deductible. And, no, a SP cannot hire the himself as an employee and pay himself a salary - - and thus take a business deduction for this amount. (Your "pay" is technically called an "owner's draw" and is not deductible as a business expense. So, you are taxed on your entire profit from the SP, not just your draw. The fact that you can't deduct salaries is one reason people incorporate their businesses. As mentioned above, corporate tax rates are lower, and with some expenses, "corporate money" is used.)

For a partnership, the same idea pertains. The money you and your partner(s) receive is called a "partner's draw" or a "guaranteed payment;" these are not deductible. A partnership's employees' salaries -are- deductible, however, just as with a SP's employees. It just happens that the employee can't be you!

With a corporation, the law considers the business a separate legal entity from you (which is why your personal assets are protected from a suit against the business). Therefore, the business can hire you as an employee and take a corporate tax deduction for your salary. You receive a W-2 at the end of the year and report your "pay" as you would any other salary (on the front side of Form 1040).

Dissolution

The SP lasts as long as the owner wants it to or until her death. At death, the SP ceases to exist, and its assets and liabilities become part of the owner's estate.

In a partnership, the situation is likewise, except that the partnership agreement may spell out a mechanism by which the deceased partner's portion may be bought out by the other partner(s).

The corporation is different. It has a life of its own. A corporation may be dissolved -only- if the shareholders vote to do it. If one of the shareholders (owners) dies, his shares pass to his heirs.

Retirement Benefits

In the past, retirement benefits made incorporation attractive, even to small businesses, but today, corporate pension plans do not have such favorable tax status.

The sole proprietor or the partner can set up a Keogh plan or a SEP-IRA, which are tax-deferred plans. (In a tax-deferred plan, you own no tax on the money in the year you contribute it; you pay tax only when you withdraw it, presumably after your earning years - that is, retirement - when your personal tax rate drops because your earned income drops or disappears entirely. There is legislation afoot which would allow pre-tax contributions -and- tax-free withdrawals at retirement.)

These tax deferred plans are the equivalent to a corporate plan.

Cooperatives

A brief word about this type of business set-up. Often a group of music teachers will form a cooperative, where the emphasis is on democratic decision-making. Cooperation and shared goals are critical in order for the cooperative to survive. A cooperative can be either a partnership, a LLC, or a corporation.

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