Starting your own business is not for the faint of heart. One element that causes a lot of concern is how to structure your new business from a legal and tax point of view. Here are some of the most common types of business entities and the benefits and downsides of each.
Entity Options – What to choose?
Sole proprietorship. The most common and least complex structure is the sole proprietorship. Sole-prop is tailored for one-owner companies. They’re easy to set up (you can use your social security number as your business ID), have little or no cost to set up, and don’t require a separate tax return. As a sole proprietor, you have full control of the company and keep all profits.
Partnerships. Partnerships share similar traits to single devices in that they are easy to administer and inexpensive to create. They also provide flexibility in relation to business income as the distribution of profits does not need to be treated proportionately. This is useful in cases where a silent partner (one who provides capital but is not involved in the day-to-day) is a key member of the company. Both the sole proprietorship and the partnership are considered ‘pass-through’ structures as the net income recognized by the company is taxed on the owners’ tax return rather than at the corporate level. While both entities have pros, there are some obvious drawbacks.
For consideration:
- Neither entity provides protection from personal liability. This implies that the owners and the business are one and the same. Thus, the personal assets of the owner(s) are not protected from creditors.
- Raising capital is also a difficult endeavor. You can’t sell stock to raise funds, and banks are often reluctant to lend to these types of small businesses.
- Another major disadvantage is FICA taxes which consist of Social Security and Medicare taxes. Net earnings (minus the self-employment tax deductible portion) will be taxed at 15.3% (12.4% for SS up to IRS limits; 2.9% for Medicare).
S-Corporation. What options are available if you want liability protection and a single tax pass-through structure? Enter the S-Corp (it is important to recognize that an S-Corp, contrary to suggestions and sole partnerships, is NOT a business structure, it is a tax election).
- After you file as a corporation (by default, all corporations are C-Corps), you must file for S-Corp status with the IRS to make this election.
- An S-Corp provides that protective barrier that insulates all business debts to your business itself and insulates personal assets.
- Also, as an S-Corp, you are technically an owner-employee, which means the compensation you receive can come in two forms: a salary and distribution of net income. Why is this important? As stated above, all net income from sole proprietorships and partnerships is subject to FICA. With an S-Corp, only the wages you pay yourself are subject to FICA.
For example, Joe’s Tacos (a sole proprietorship) has net profits of $100,000, which is taxable income to it. With respect to those taxes, his self-employment taxes would amount to $14,130 ($100,000 of net income minus the deductible portion of the self-employment tax (7.65%) x (15.3%). Conversely, if Joe is an S-Corp, he can pay himself a salary of $60,000. As an S-Corp, Joe only has to pay FICA taxes on his salary, which comes to $9,180. The remaining $40,000 dollars of earnings would be subject to income tax only.
So why not just elect S-Corp status and take all the income as distributions? Well, the IRS is keen on that strategy and has ruled that you must pay yourself a ‘reasonable salary’ (what you would pay if you hired someone for the same position) in order not to use the S-Corp as a tax avoidance solutions.
While the S-Corp carries many positive attributes, it comes with its share of disadvantages:
- S-Corps require a fully legal setup, which results in increased costs as you will typically need the services of an attorney and an accountant.
- Additionally, profits and distributions must be distributed according to ownership, removing some of the partnership’s flexibility.
- There cannot be more than 100 shareholders, all of whom must be US citizens or legal residents.
- You can also have only one class of shares. Thus, there can be no preferred shareholders.
Limited liability company. The LLC (Limited Liability Company) is a hybrid type as it offers the ease of creation and maintenance similar to that of sole proprietorships and partnerships, while offering personal liability protection comparable to an S-Corp.
- The LLC is just a legal entity, which means it is not a taxable business structure and you can choose which tax arrangement is right for your business. By default, single-member LLCs follow the single tax structure, while multi-member LLCs reflect partnerships.
- You can also choose to be taxed as an S-Corp for your LLC. Remember, an S-Corp is simply a tax election. This means it can offer additional flexibility in payment structure and subsequent taxation.
summary
Deciding how to structure your business can be an arduous process. If this process becomes too overwhelming, consider talking to your financial advisor to get their input and contact an attorney when necessary. Taking the time to work through the benefits and drawbacks of each structure can yield better results for your business.
Mathew Ryan, MBA, CFP, EA is a Financial Planning Specialist with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Mathew at mryan@bedelfinancial.com.
