eNewsletter

ISSN:1559-5447
Vol. 1, No. 3
February 21, 2006

In This Issue:
-Insider Secrets about Corporations: Or..."Why Should I Incorporate?"
-First Things First: Reading Your Financial Statements

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A Message from Germaine...

What a wonderful week--I hope yours was a nice as mine! I just returned from the desert--the Palm Springs area--where the beautiful view of golf courses and palm trees against the majestic mountains and foothills soothed and enthused me! (See the photo to the right!)

Insider Secrets about Corporations: Or,
"Why Should I Incorporate?"

• "Why should I incorporate? I can just do this business as a sole proprietor, right?"
• "Isn't it complicated and expensive to form a corporation?"
• "I run my business with my spouse, and we have a partnership. Why would we need to have a corporation?"

These have to be the most frequently asked questions that I--and my own financial and legal advisors--get from our clients. Statistics show that the vast majority of people (both inside and outside the US) who operate small business or home-based business are sole proprietors or mom-and-pop shop-type partners. Yet, leading authorities on small business estimate that at least 90% of all small business and home business entrepreneurs would benefit from incorporating and using a corporation as an essential component of their overall business structure.

If this is true, why do so many entrepreneurs elect to operate as sole proprietors and general partners anyway? And why would you be better off incorporating?

The answer to the first question is usually either (1)ignorance of the tremendous risks of operating in this manner or (2) lack of familiarity with corporations and other legal entities and the ease with which they can be established. I should add that if the sole proprietorship is perilous, the partnership is more than twice as bad. This is because the informal partnership is by default a general partnership, in which each partner is responsible for all actions of the company, including decisions made by the other partner in which she did not participate. Now that's frightening!

To answer the second question, we must first establish what a corporation is precisely. A corporation is an artificial legal entity that is separate from its owner/shareholders in the eyes of the law. The wealthy have learned that there are at least three major advantages that make the corporation an essential component of your business structure.

1. Asset Protection.
   

   The single most important benefit of the corporation is protection it affords for your personal assets.
   
   The corporation is created when you file appropriate documents--"Articles of Incorporation" in the United States--to the appropriate state legal authorities. A corporation cannot be formed through some private agreement between the parties who elect to form it. It can only come into being by the state in which it is formed creating it, and it has the rights and obligations established by the laws of that state.
   
   Most important here is the notion of the corporate veil--this is the shield that separates your business assets and activities from the private person and assets of the owner/shareholder(s). Because the corporation is a separate legal person, if you are a consultant or translator, for example--or own a small store--and someone claims that that they have suffered injury from your business (say, from a poor translation or a slip on your wet floor), and files a lawsuit, only the assets of your business are in jeopardy. The claimant cannot touch your personal residence or your automobile if these are owned by you and not your corporation.
   
   There are significant differences among individual states and the degree of protection that they afford to the corporate veil. In California, for instance, there are a number of occasions--too many for comfort--in which the corporate veil has been pierced, thus allowing financial predators to seize the personal assets of an entrepreneur. This is almost never happened in Nevada, making it the state of choice for entrepreneurs seeking asset protection.
   
   We will be devoting a separate article to the Nevada corporation in depth in a future issue of this eNewsletter. It is important to note for now that an additional advantage of the Nevada corporation for many is that Nevada has no state income tax. If you use a Nevada corporation to conduct business in your own home state outside Nevada (such as California, our own home state), you may still be subject to state income tax. Because of the superior asset protection afforded by the Nevada corporation, however, it may still be worth while for you to establish a Nevada corporation. Large numbers of entrepreneurs from other countries as well as other states establish Nevada corporations for precisely this reason.
   

2. The S Corporation versus the C Corporation: Know Which is Right for You
   

   There are two types of corporations: The S-Corporation and the C-Corporation. The S corporation, like the limited liability company and the limited partnership is a pass-through entity. That is to say that the corporation is itself not taxed as an entity--instead the net income passes through to the shareholders (such as a husband and wife), and is taxed on the individual tax returns of the shareholders/owners.

   There are situations in which establishing an S corporation would be preferable to using a C Corporation. If you have significant income from a job, for example, and you anticipate significant losses in early years and you don't anticipate that your business will earn over $150,000, an S corporation will be your best choice. And the concerns (addressed below) about being categorized as a personal service corporation do not arise with an S corporation. However, there are limitations on who can be members of an S corporation, and there are limits on employee benefits in an S corporation.
   
   A sophisticated business structure will probably make use of both the C and the S corporation. On the other hand, because of the nature of corporations, you will never want to use either type of corporation to hold real estate. Instead you will want to use a limited liability company or a limited partnership. However, if you are a real estate investor, there might still be room for an S- or C-Corporation in your overall business structure. For example, a corporation could be used to manage your properties held in another entity.
   
   Or--and this is a strategy that could be used for conducting various sorts of business-the corporation could be part of another business entity. For example, if you wish to operate a limited partnership, you will need to have a general partner. But the general partner is responsible for all decisions made and all liability resulting therefrom--the general partner, in short, has unlimited liability. Thus, an intelligent option is to use an S- or C-corporation to be the general partner. This way you have a general partner with the limited liability associated with the corporation.
   

3. Learn How to Manage Your Corporation Properly to Keep the Corporate Veil Intact
   
   Regardless of where you establish your corporation, you will need to make sure that you observe appropriate formalities--otherwise your corporate veil can be pierced very easily, thereby defeating the entire purpose of setting it up. Even if you have an accountant who handles your bookkeeping and tax returns, it remains your responsibility to assure that you are doing this correctly.
   
   This involves holding regular meetings and maintaining minutes in your record book, issuing stock certificates, and other formalities. Fortunately, this is relatively painless if you have the resources. We have identified some excellent resources and tools on our
   website (http://www.wealthstrategies202.com/resources.htm).
   

The Personal Service Corporation

A final issue that may arise, particularly for independent consultants, translators, and other professionals, concerns the "Personal Service Corporation." There are two separate categories of professionals who may be affected by this problem: Those, such as lawyers, accountants, psychologists, and health care professionals, who are required by their state laws to incorporate as professional corporations. These corporations are automatically classified by the IRS as personal service corporations.

In addition, the IRS has broadened the definition of "personal service" to include any work, such as translation or consulting, that is personally rendered by the owner/shareholder. This is of particular concern if you are operating on your own as an individual or as a couple. If 95% or more of your earnings come from work in that personal service activity, the corporation becomes qualified as a personal service corporation.

The reason that this is of concern is that a personal service corporation incorporated as a C corporation is subject to a flat 35 percent tax rate and to a lower ceiling ($150,000) for application of the accumulated earnings tax (normally $250,000). However, this is not an insurmountable obstacle to enjoying the benefits of incorporating:

Certainly, you can, if you don't mind exposing all your personal assets to risk, paying higher taxes, and finding yourself more likely to be subject to an IRS audit. Some people prefer to do things the hard way--but, armed with the right information and resources, there's no reason why you should have to.

Even if you decide to allow a tax attorney to help you with the formalities, it is better to do so armed with the knowledge you need to judge whether the recommendations she makes are in fact in your best interest.

At the very least, you'll know enough to head immediately for the nearest exit if any “expert” you consult tells you that you “don't need” to establish a separate legal entity to run your business.

As you consider which business entity you want to use, the decisions you make will depend heavily on your current financial situation, both personal and professional. But do you know how to read a financial statement on your own? Do you know how to draw up your own personal and business financial statements?

Knowing how to do this is an essential skill not just for entrepreneurs but for everyone. However, for the entrepreneur having this skill can mean the difference between having a thriving business that continues to thrive and winding up in bankruptcy. The annals of the bankruptcy courts are strewn with cases of entrepreneurs who entrusted their accounting to others and, not knowing how to read the financial statements of their own businesses, were surprised when they found that the business was ultimately unsustainable. The purpose of this article is to help prevent this from happening to you--and to arm you with the skills you need to structure your business to your benefit from the outset.

Your Two Major Financial Statements

There are two major financial statements that every entrepreneur should know how to read and (ideally) prepare or have prepared in their financial software (we recommend QuickBooks):

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