YOUR INDEPENDENT CONTRACTOR BUSINESS: CHOICE OF ENTITY
I. Introduction		Many high tech industry consultants and professionals work for a single company on a particular project over an extended period of time. Although this is considered a normal working relationship within the industry, the federal and state taxing authorities as well as state agencies in charge of employment issues (collectively "government") are suspicious of these arrangements and often consider them merely a ruse for the traditional employer-employee relationship. Thus, there has been an on-going effort by government to recast an independent contractor relationship into the more familiar employer-employee context. Simply stated: government is not comfortable with this relatively new business arrangement and can be hostile to it, because it views the arrangement as a potential tax dodge - a way to circumvent the taxes and insurance payments companies pay when the traditional employer-employee is involved. If successful, recasting the independent contractor relationship will cost both the company and the worker higher taxes. For the company, the government could require extra employment taxes, penalties and interest, as well as additional insurance premiums. The contractor may lose some or all business deductions - automobile, home-office deduction, deduction for business portion of utilities, advertising and marketing, entertainment and travel. Also, the contractor will be limited in the choice of retirement, benefit and health plans.
II. Form 1099 - the Government's Most Potent Weapon		Form 1099 MISC is the primary tool used by government in employment tax audits. Companies are required to issue Form 1099s to report the amount paid for services to contractors doing business as individuals (sole proprietors) and non-corporate entities (partnerships, trusts and LLCs). Payments to corporations are exempt from the Form 1099 requirement. A Form 1099 issued to a business using an employer identification number or "EIN" (a tax identification number obtained just for the business) draws less scrutiny; however, government may consider suspect a Form 1099 issued to a sole proprietorship which uses the individual's social security number as the tax identification number. Of course, if a company is not required to issue a Form 1099, there is no automatic paper trial generated between company and contractor.
III. Choice of Entity		Whether a contractor does business as an S corporation, LLC or sole proprietorship, the individual owner reports the income and pays the taxes, not the entity. Note: California imposes a fee for a corporation and LLC, but not for a sole proprietorship or a partnership. Operating a business as a sole proprietor and reporting income and expenses on Schedule "C" is the most risky form of doing business from a potential government examination standpoint. Not only are the chances of being selected for a audit increase -- sole proprietorships have a 1 in 47 chance of being selected for audit; by contrast, the odds of an S corporation are just 1 in 233 -- the Form 1099 is usually issued under the contractor's social security number, indicating that the contractor is an individual, rather than a business. The best choice of an entity with respect to the independent contractor relationship is an S corporation, since a Form 1099 is not issued. Thus, the Form 1099 link between company and contractor is not present. The drawback to using an S corporation is that a separate tax return is filed, thereby increasing accounting costs. The next best choice is an LLC. Although a Form 1099 must be issued to an LLC, there should be a company name and EIN associated with the LLC, which should indicate to an auditor that the payment was made to a company. A single-member LLC may elect to be taxed as an individual on Schedule "C", which means there is less paperwork involved because a separate tax return is not filed.
IV. LLC vs. S corporation		This discussion is limited to the independent contractor issue. There are tax differences between an S corporation and an LLC, however, for a single person entity, most of those differences disappear. Note: Both entities pay a minimum $800 annual franchise tax to California. Both entities offer limited liability protection, which means, in general, that an individual's personal assets are not at risk if the company owes money to creditors, unless there is fraud involved. ADVANTAGES TO AN S CORPORATION: The main advantage to an S corporation is that no Form 1099s are issues. This is an attractive feature to companies considering hiring an independent contractor; consequently, from a marketing perspective it is smart to conduct business through an S corporation. Sometimes, the hiring company will only want to work with S corporations. Also, in some instances, the S corporation may pay lower state taxes than an LLC. (See the comparison tax chart in the Appendix). DRAWBACKS TO AN S CORPORATION: The entity is a corporation; it files a separate tax return, reporting its income and expenses. Contrary to popular belief, a corporation does not have to record and maintain corporate minutes, provided the corporation elects to become a "statutory close corporation". Once there is more than one shareholder, an S corporation is less flexible than an LLC with respect to tax planning and distributions. ADVANTAGES TO AN LLC: An LLC is easy to form, there are no corporate formalities such as corporate minutes and the LLC has great latitude with respect to distributions when there is more than one owner. A single member LLC may elect to be taxed as a disregarded entity, in which case the taxpayer reports income and expenses on Schedule "C", as though it were a sole proprietorship. DRAWBACKS TO AN LLC: The main drawback to conducting business as an LLC is that a Form 1099 is issued. Also, depending on the circumstances, there could be a higher state tax payable if the entity has gross income in excess of $250,000 a year, when compared to an S corporation. SOLE PROPRIETORSHIP: The only advantages to conducting business as a sole proprietorship are simplicity and saving the $800 annual franchise tax. The drawback, of course, is a much greater chance of facing an audit on the independent contractor relationship. Also, there is no limited liability protection for the owner.
V. Conclusion		With respect to the independent contractor vs. employee issue, the S corporation is the most advantageous form of conducting business, since it eliminates the Form 1099 requirement, thereby greatly reducing the risk of audit.
VI. Resources		For excellent do-it-yourself products on forming and operating an S corporation or LLC, go to Nolo Press on-line/ - Business and Human Resources). Check out LLCMaker and Incorporate Your Business for books and software, including forms, for forming an LLC or S corporation. Forms for filing a California LLC or a corporation may be found on the Secretary of State's website. Use corporate form #2 (domestic close corporation) under Formation/ Qualification Documents - for sample articles of incorporation for a statutorily close corporation. Use LLC form #1 Formation Documents, LLC-1, for the formation of an LLC. Attachments: 1. State tax comparison between an LLC and an S corporation. 2. Sample Articles of Incorporation for a statutory close corporation. 3. Sample management agreement for a statutory close corporation.

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All contents copyright ? 2008 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet(TM) is a trademark of Robert L. Sommers.

Attachments

:

LLC Fee Structure in California - Based on amount of gross income.

Gross Income	LLC Tax
0-$249,999	$800
$250,000-$499,999	$1,700
$500,000 - $999,999	$3,300
$1,000,000 - $4,999,999	$6,800
$5,000,000 or more	$12,590

S Corporation Fee = 1.5% of taxable income, after payment of salaries

.

Examples - Taxable Income	S Corporation Tax
0 - $53,300	$800
$100,000	$1,500
$250,000	$3,750
$500,000	$7,500
$1,000,000	$15,000
$5,000,000	$75,000

[Sample Articles of Incorporation for a Close Corporation]

ARTICLES OF INCORPORATION OF ACME DEVELOPMENT, INC

The name of this corporation is ACME DEVELOPMENT, INC.

The purpose of this corporation is to engage in any lawful act or activity for which a corporation may be organized under the GENERAL CORPORATION LAW of California other than the banking business, the trust company business or the practice of a profession permitted to be incorporated by the California Corporation's Code.

The name and address in the State of California of this corporation's initial agent for service of process is:

This corporation is authorized to issue only one class of shares of stock; and the total number of shares which this corporation is authorized to issue is 10,000.

This corporation is a CLOSE CORPORATION. All of the corporation's issued shares of stock, of all classes, shall be held of record by not more than 35 persons.

Dated: ________________, 2008

____________________________

(signature of incorporator)

Joe Smith

(typed name of incorporator)

I hereby declare that I am the person who executed the foregoing Articles of Incorporation, which execution is my act and deed.

____________________________

(signature of incorporator)

Sample: Close Corporation Agreement

THIS AGREEMENT is entered into as of the first day of May, 2008, by and between Joe Smith as Manager ("Manager") and Joe Smith ("Investor"), as shareholder of ACME Development, Inc., a California statutory close corporation.

RECITALS

A. Investor owns 1,000 shares, of the capital stock of ACME Development, Inc., a California close corporation ("ACME"), which shares constitute all of the issued and outstanding shares of ACME.

B. Investor desires to appoint Manager to manage the ACME and to subject his shares of capital stock in ACME to a shareholder agreement as provided in Section 300 of the California Corporations Code.

NOW, THEREFORE, it is agreed as follows:

1. MANAGEMENT OF CORPORATION: Notwithstanding anything to the contrary contained in the Bylaws of ACME and except as required by the California Corporations Code, the business and affairs of ACME shall be managed and all corporate powers shall be exercised by or under the direction of Manager; provided, however, that Manager shall have no authority to do any of the following without the prior written consent of Investor, in the capacity as the shareholder:

(a) Issue or sell on behalf of ACME any additional shares of its capital stock;

(b) Sell all or substantially all of its assets; or

(c) Cause ACME to engage in any business other than that in which it is presently engaged.

No meetings of shareholders or directors need be held but may be called as provided in the Bylaws of ACME.

Manager agrees to indemnify and hold harmless Investor and his successors and assigns from and against any claim, loss, damage, liability or cost (including reasonable attorneys' fees) asserted against or incurred by Investor as a result of such management and exercise of corporate powers by Manager.

2. BOARD OF DIRECTORS: Investor is the sole director of ACME, and agrees that he or his respective designees shall constitute the sole directors of said corporation throughout the term of this Agreement. The board shall perform such functions as are not otherwise delegated to Manager or provided for under this Agreement.

3. RECORDS AND REPORTS: Manager shall cause ACME to maintain the books, records and other documents as required by Section 1500 of the California Corporations Code. Notwithstanding any waiver thereof contained in the Bylaws, Manager shall cause ACME to furnish to Investor an annual report referred to in Section 1501(a) of said Code, which report need not be audited.

4. TERMINATION OF AGREEMENT: This Agreement shall remain in effect until terminated by mutual agreement of the parties, or until ACME ceases to be a close corporation as defined in California Corporations Code Section 158. In the event of an original issuance of shares by ACME to a new shareholder who does not become a party to this Agreement, this Agreement shall nevertheless continue in full force and effect to the extent it is enforceable apart from the provisions of California Corporations Code Section 300(b).

5. MISCELLANEOUS:

(a) This Shareholders' Agreement shall inure to the benefit of and be binding upon the successors and assigns of the parties hereto.

(b) This Shareholders' Agreement shall be governed by and construed in accordance with the laws of the State of California.

(c) A duplicate original of this Shareholders' Agreement shall be filed with the Secretary of ACME for inspection by any prospective purchaser of shares of the capital stock of ACME.

(d) The share certificates of ACME shall bear the legend required by California Corporations code section 418(c), and also the following: "the shares represented by this certificate are subject to transfer and other restrictions (the date of the within agreement)."

IN WITNESS WHEREOF, the parties hereto have hereunto affixed their signatures as of the day and year first above written.

___________________________________

Joe Smith - Manager

___________________________________

Joe Smith - Investor