I have been in business for over twenty years, and in that time I have come across many businesses that are just starting out that have to ask themselves the question of entity selection for their small business. In the past, I always had a blanket answer, however after twenty years of experience let me give you the best advice that I can give you: “It depends.”
Typically businesses just starting out unintentionally form sole proprietorships. They decide to go into business and by default, become sole proprietors. A sole proprietorship is very easy to open and maintain. You just decide to go into business, and there you are. There is minimal, if any paperwork to file. You can do not need an Employer’s Identification Number unless you have employees, you don’t have to have a separate bank account, as I said you just simply decide to go into business.
The main problem with a sole proprietorship is simply this: full legal liability and self-employment tax. If as a sole proprietorship you make a mistake, or someone is not happy and they sue you and win a judgment, the judgment is entered against you personally, thus exposing all of your personal assets to the collection of the judgment. This sounds pretty far-fetched, but it happens every day.
The other downside to a sole-proprietorship is the fact that you have to pay self-employment tax on your earnings and profits. Self-employment tax is simply Social Security and Medicare tax. The tax is at 15.3 percent of your net profit (gross income minus expenses). This tax is in addition to any Federal Income Tax that you may owe on your profits. Even if you are in the 15 percent tax bracket you could very easily expose your profits to 30.3 percent in taxes. This can add up quickly in the higher tax brackets.
The old standby solution to a sole-proprietorship would be forming a corporation. A corporation is a legal entity that enjoys limited legal liability. The shareholder (owner) of the corporation is only liable for their investment in the corporation in most instances. The way corporations are taxed are either as a C-Corporation or a Subchapter S-Corporation. Both of which have their uses. A C-Corporation pays tax at the Federal and sometimes State level. If any money is taken out of the corporation as profit, the shareholder must pay taxes again on their personal tax return. This is known as double taxation. It may sound stupid as to why anyone would want to be taxed as a C-Corporation, but in some cases it makes sense. I will get into that later.
Then you have Subchapter S-Corporations. S-Corporations do not pay tax. They are what is known as flow-thru entities. The S-Corporation files a return, and the profits, and or losses flow to the shareholder to be claimed on the shareholders personal income tax return. The benefit to this is that the shareholder only pays tax on this money one time. The other benefit is that when the profits flow to the shareholder they are not subject to self-employment tax. HOWEVER, S-Corporations come with very strict hard and fast rules. For starters to qualify as an S-Corporation you must have less than 100 shareholders. All of the shareholders must be U.S. Citizens or Resident Aliens. Then all of the shareholders must “reasonably compensate” themselves. Reasonable compensation boils down to very strict rules on how a shareholder can pull money out of the S-Corporation.
Another entity choice is a Limited Liability Company (LLC). LLC’s are legal structures much like corporations, however they have more flexibility than a corporation. For instance, an operating agreement (the instrument that governs an LLC) can be written in such a way that favors one or more of the partners of the LLC. Thus creating a hierarchy of membership. Another benefit to an LLC is that you can make an election on the way that an LLC pays tax. You can be taxed as a sole-proprietorship, partnership, C-Corporation or S-Corporation, and it doesn’t change your legal structure of the LLC.
In the past, I would typically recommend a new business form an LLC and have it taxed as a Subchapter S-Corporation. However, my default advice had problems. For starters, when the profits flow to the shareholder of an S-Corporation they can be taxed as high as 39.6 percent. Not to mention the reasonable compensation requirements that I mentioned earlier. Secondly, S-Corporations are audited more by the Internal Revenue Service because of the reasonable salary requirements. This can create a mess for the shareholder.
Today, I look at the client’s over all goals with their companies, and advise accordingly. If the company is looking to make a lot of money in the first year, I like to recommend LLC’s taxed as C-Corporations. The highest corporate tax bracket for a C-Corporation is 35 percent. Not to mention that the C-Corporation can pay taxes as low as 15 percent on income of less than $50,000. This can be a very useful tool to the shareholders of a C-Corporation.
Another recommendation that I have begun using would be a combination of an S-Corporation and a C-Corporation to minimize the tax exposure of the client.
As you can see there is never a one size fits all solution for entity structures, and you should be made aware of that before it is too late in the game to switch.