Choosing the right business structure is an important decision and one that should be made wisely. There are advantages and disadvantages that go along with each one. Understanding those differences is critical in making your first decision as a business owner. Then as your business grows, you must reassess to be sure the structure you chose is continuing to work for your benefit. If it’s not, then it may be time to change.
Here are some questions to ask when choosing your business structure:
- How much revenue is your business earning
- Are you paying too much in self-employment tax
- Do you have/need liability protection
- How many business owners are there
- Do you have investors
- Where are you conducting business
- Where do you live
- Do you have multiple locations
What choices do I have?
There are five business structures from which to choose.
Each of the above comes with its own set of rules. Understanding those rules is critical both legally and financially.
Which one is best for me?
That all depends. Here are a few more questions to ask yourself:
- Do I want to be able to pull cash out of my company when I need it for personal purposes
- Do I want a steady paycheck that withholds taxes for me
- Do I have other sources of income like investments
- What tax bracket am I in
Let’s break this down.
If you are a single owner, the most common structure is either a sole-proprietor or a single-member LLC. Single owners may be set up as corporations, and I’ll address that later. So what’s the difference? Simple – liability. These two structures are essentially the same except an LLC gives you additional liability protection. As an LLC, you are required to have a separate EIN or tax ID number for your business. You may not operate under your social security number. By doing this, you are setting up as a business identity separate from yourself. The IRS refers to this as a disregarded entity. This separates your business from you. It provides protection to your personal assets because all of your business assets are tied to the business entity. In the case of a lawsuit, only your business assets would be at risk. If liability is not an issue, you may choose to operate as a sole-proprietor and if needed, get liability protection from an umbrella policy.
From a tax point of view, sole-proprietors and single-member LLCs are treated the same. Both structures are required to file their business income and expenses on a Schedule C on the owner’s individual 1040 tax return. This means no additional tax return is required. Additionally, any loss incurred in the business will offset other sources of income that the individual may have.
The downside of these entities is that both are subject to self-employment tax. Since the owner is both the employer and employee, they are required to pay both the employer and employee portion of payroll tax which when combined comes to 15.3%. This percentage is charged on all ordinary net income generated by your business. Once your business income reaches a certain level, you may wish to change your structure in order to save on self-employment tax.
These two structures are certainly some of the easiest to set up and operate. As a sole-proprietor, all you have to do is start. You do not need an EIN or even a separate bank account, although one is HIGHLY recommended. As an LLC, there is a bit more to do to get started. You must file the Articles of Organization with your state, pay an annual filing fee, and obtain an EIN from the IRS. But that’s a small price to pay for the liability protection it provides.
Now let’s talk about pass-through entities. These are Partnerships and S-Corporations.
Partnerships are LLC’s that have two or more owners. Like the single-member, they too need to file Articles of Organization with their state, pay an annual filing fee and obtain an EIN from the IRS. Since there are two or more members they may also wish to have a partnership agreement that details the partner percentages of profit and loss and other terms. The IRS does not require that a partnership agreement is created. One can be formed on a hand-shake alone. But it is good practice and recommended there is some sort of agreement in writing. In a partnership, there must be at least one person designated as a general partner and the others may be limited partners. The general partner is personally liable for any debt incurred by the partnership. Limited partners are not held personally liable.
S-Corporations may have one or more owners or shareholders. In order to incorporate, you need to file Articles of Incorporation with the state in which you conduct business, pay an annual filing fee and obtain an EIN from the IRS. There are a few more administrative requirements when you become incorporated like issuing certificates of stock and keeping and maintaining a meeting minutes book. A good attorney can help you with these.
The primary reason to set up as an S-Corp is for liability protection and to save on self-employment tax. Unlike the partnership, all shareholders have limited liability. The shareholder of the S-Corp is an employee of their own corporation. So when it comes to payroll tax, the corporation pays its share (7.65%) and this is a business expense deductible to the corporation. The shareholder (employee) pays its share (7.65%) on its total wages. So for instance, if you were a sole-prop and your net earnings were $100,000 you would pay 15.3% in self-employment tax on that $100,000 or $15,300. If you were operating as an S-Corporation and paid yourself a wage of $50,000 then you would only pay 15.3% of $50,000 or $7,650 and half of that ($3,825) would be a deductible expense to the corporation. So there can be significant savings from being an S-Corp.
Tax Planning Tip
A great tax planning strategy is to set up as an LLC and make a tax election to be taxed as an S-Corporation. LLC’s have a feature that no other structure has. They are allowed to choose how they want to be treated for tax purposes. If no choice is made, the default is a disregarded entity for a one-member LLC (taxed as a sole proprietor) or a Partnership for two or more members. But you can make a choice to be treated as a Corporation. You will be taxed as a C-Corp or S-Corp depending on which you choose. The benefit is you don’t actually have to incorporate. You are still an LLC. You are just being treated and taxed as a corporation. But in order to get this treatment, you must act like a corporation. That means you must follow the same rule as corporations do and file a corporate tax return each year.
Another reason to consider incorporating as an S-Corporation is to build business credit. Since an S-Corp has its own tax ID, after you’ve been in business for a while, you can begin to establish credit and borrow funds solely in your company’s name. This may be more preferable to some business owners rather than taking out personal loans to fund their business.
The last structure to discuss is the C-Corporation. Most large corporations are organized as C-Corporations. Usually for very specific reasons, like to raise capital or they plan to go public. That’s not to say you need to be a large corporation to choose this structure. Plenty of small businesses operate in a C-Corp structure. But is it really the best choice? I’ve met many small business C-Corp owners that simply said their attorney advised them this was the best structure. No offense to attorneys, they certainly have their place, but not when it comes to tax. Unless of course, they are a tax attorney.
In general, C-Corporations are allowed to take additional deductions that are not available to S-Corporation owners. Items such as disability insurance, health reimbursement plans, daycare assistance, educational assistance, cafeteria plans. These are not available to an S-Corp owner who owns greater than 2% of their company (which is just about every S-Corp owner). On the surface, it seems like, hey I get more to deduct with a C-Corp so let’s do it. But let’s go a bit further. Many of these benefits, if offered in a C-Corp structure must be offered to everyone, not just the owner. And not all of these benefits even apply to many small businesses.
The other issue that often comes up is the C-Corporation tax rate is 21% whereas an S-Corporation is taxed at the owner’s individual rate which may be as high as 39%! Seems like a no-brainer. But let’s go a little further. A C-Corporation pays the owner a reasonable salary and then pays 21% on its net income. Sounds awesome. But where does that net income go? It’s locked in the corporation. It’s earnings of the corporation. Let’s say you the owner wants some of that money. Can you get it? Sure, as a dividend taxed at 20%. That’s double taxation. The corporation already paid 21% tax on the net income and you the owner will pay another 20% if you want access to the cash.
So how else can you pull money out of the corporation? Increase your salary, give yourself a raise. Now you’re back to paying more in payroll taxes.
One of the greatest benefits of an S-corporation is the ability to take cash out when needed. This is called a shareholder distribution. There is no additional tax paid on this amount as long as the amount distributed doesn’t exceed your basis. To a small business owner, this can be a life-saver!
The new tax law also established a Qualified Business Income deduction (QBI). This is a new benefit that is available to all sole-proprietors and pass-through entities. Qualified businesses only pay tax on 80% of their net income. 20% is tax-free.
So let’s circle back to the C-Corporation. They are not entitled to this QBI deduction. So the 21% tax rate may not result in a lower tax bill once the QBI deduction takes effect. The only way to know is to crunch the numbers.
Starting a business should be an exciting venture. One that hopefully brings the owner much success. Choosing the right entity is only one of many important decisions that must be made, but one that can save a lot of money if planned appropriately. Choose wisely.