Your choice of company structure can cost or save you thousands of dollars every year in relation to Legal Protection, Taxes, Paperwork, and Stress Level, and this decision affects your business. The structure you choose when establishing your business is perhaps more important than you realize, and while it doesn’t change how you operate your business from day to day, it does affect how the law views your business.
Your Day-To-Day Operations Will Be the Same
Regardless of which structure you select for your business, the overall way you perform your job remains unchanged. If you are running a Landscaping Company, you are still Mowing Lawns, Trimming Hedges, and Dealing with Customers, whether or not you have filed any additional business-related paperwork. You will not be given an upgraded lawn mower just because you’ve filed more paperwork with the State.
Why There Are Different Business Structures
When you begin your business as a Sole Proprietorship or LLC, the State must first determine whether your business is YOU, or whether your business is a separate entity, of which YOU happen to be the owner. This single question helps to distinguish between a Sole Proprietorship and an LLC, and later on, between S Corp and LLC tax treatment.
The just – start option for sole proprietors is the default business form. Your business is established when you awake, are awakened by thoughts of earning a profit, and declare it a business without the need for paperwork, registration fees, ongoing compliance, etc. It is easy and quick.
However, the ease of starting a business as a sole proprietorship also has its disadvantages. If you are sued as a sole proprietor, the lack of separation between personal and business assets may cause you to lose your home, car and/or personal bank account due to a judgment against the business.
As compared to the sole proprietorship, creating a limited liability company (LLC) does not alter how the owner works in the business or how the owner operates on a daily basis. It simply creates added protection for the owner through the creation of a separate legal entity. Therefore, if you have created a separate legal entity for your business, only the assets of the business will be at risk in the event that the business has a problem.
Creating an LLC does require compliance with certain laws such as filing an operating agreement, obtaining an employer identification number (EIN), paying an annual tax to the state(s) in which you conduct business, and filing necessary tax returns as required each year. While LLCs do require additional paperwork and an annual tax payment, the additional layer of protection offered through the creation of an LLC is not available to sole proprietor.
Additionally, many people are unaware that for tax purposes, both sole proprietorships and LLCs are treated the same by the Internal Revenue Service (IRS). From the standpoint of taxes, sole proprietorships and LLCs are both considered “pass-through” entities. Therefore, the business is not required to pay taxes on its profit, and the owner’s profit will appear on the owner’s tax return as it is reported on Schedule E. This avoids the double taxation which would otherwise occur if corporate taxes were imposed on the business. Therefore, the tax process for LLCs and sole proprietorship is relatively uncomplicated.
There is no way to avoid self-employment taxes from either a sole proprietorship or an LLC; both will have to file and pay self-employment taxes at 15.3% on their profits, which consists of both Medicare and Social Security taxes.
When considering how much your income would be taxed if you were an employee, keep in mind that the 15.3% may seem like a large number. However, employees typically only see half of this amount deducted from their paycheck. Their employers are responsible for the remaining half. Therefore, as a self-employed individual, you will also be required to pay the employer portion in addition to what you would normally pay as an employee.
An S-Corporation (S-corp) is not a type of LLC; rather, it is an election made by individuals to have their business treated as an S-corp for tax purposes. An S-corp is simply a different way to look at your business for tax purposes. You are still legally operating as either a sole proprietor or LLC, but for tax purposes, you will now be treated differently.
S Corp tax treatment means you must take a reasonable compensation as a W-2 employee which will require payroll, payroll taxes, and additional reporting. Yes, it requires more work than a traditional LLC. However, the benefit of S Corp taxation is that the business income earned after you receive your salary will not be subject to the self-employment tax. Depending on the size of your business, this could amount to thousands of dollars each year.
For example, if your business makes an additional $40,000 above and beyond your W-2 salary, the standard self-employment tax would take a great deal of that money with a 15.3% tax rate. If you were taxed as an S Corp, all that additional income would be excluded from self-employment taxes. That money could stay in your pocket.
Which Type of Entity Should You Select?
- If you are a beginner, do not have a lot of money invested in your company, and are in a low-risk environment, a sole proprietorship is a great option for testing your business idea.
- If you are in the beginning stages of your business, are creating a serious business, have assets to protect, and run the risk of being sued, LLCs are a great option.
- If you have a successful, established company with a steady income stream in addition to your salary, it may be worth considering electing S corporation status to reduce self-employment taxes.
The type of business structure you choose should be based on your individual needs, as well as those of your company. It should take into account your ability to protect your assets, operate efficiently, and keep as much of your profits as possible. Start with the basic business entity that best fits your circumstances and costs. After you begin to show profits, consider the tax implications of your business structure.
