Casey Moss Tax & Accounting

Entity Structure for New Businesses

How to choose between a C-Corporation, S-Corporation, LLC, or Sole Proprietorship for a new company.

So you’re starting a new venture and you’re thinking, “I know I’m supposed to form a Corporation or an LLC, but I don’t know what the hell I’m doing.” Not to worry! This is a process that nearly every business goes through in their early stages, and it’s relatively easy to narrow down the choices. I’ll take you through the pros and cons of each and explain when “S-corporations” come into play.

 

The majority of companies can be narrowed down to 3 choices for entity structure:

  • Sole Proprietorships
  • Corporations
  • LLC’s
 

While there are other options for entity structure, these are the three most common for small businesses, which are my forte. Let’s break down each of these options.

Sole Proprietorships

One great thing about capitalism is that you can decide to start a company and begin operating immediately. No paperwork. No lawyers. No accountants. You can just start making money. This is a sole proprietorship, and here are the pros and cons:

Pros

  • No paperwork – start making money and just keep track of your income and expenses for tax time.
  • Save money in professional fees – there is no business tax return for a sole proprietorship. This means you don’t have to pay someone to prepare a separate tax return for your business and one for your personal. The business activity is reported on a schedule C on your personal tax return. There are also no annual filings that require lawyer involvement.
  • Operate under a DBA for branding purposes – you can file with your state to operate under a business name instead of your personal name. Obtain a DBA from your state and an EIN from the IRS and you’ll also be able to open a business bank account under your DBA name. This means that your customers can make checks out to your business name instead of to you personally.

Cons

  • Unlimited liability – people can sue you for everything you’ve got. Let’s say your sole proprietorship takes off and you have $20 million in personal assets – Lamborghinis, helicopters, etc. If your company later fails, creditors may be able to sue for your personal assets since you don’t have a separate entity in the eyes of the law.
  • Self-employment taxes – when you’re a sole proprietor, your net income (after expenses) is subject to what’s called “self-employment taxes.” This is just a fancy way of saying FICA, or social security and Medicare tax. When you’re an employee somewhere, 7.65% of your gross earnings are withheld to pay into social security and Medicare. Your employer is also liable for 7.65% to help fund these programs. So for every paycheck, 15.3% of the total gets paid in. When you are self-employed, you are liable for both the employee AND the employer portion. That means 15.3% of your net business income is paid in with your tax return each year ON TOP of income taxes. This is why you may hear some self-employed individuals swearing that they pay 30% or more in taxes each year. A big portion is likely self-employment tax.
 

Sole proprietorships make the most sense for side-hustles that create a small amount of income and don’t create significant liability issues. If your side-hustle becomes your main-hustle, it makes sense to start considering other options.

Corporations

There’s something that feels nice about having “Inc.” after your company name. Unfortunately there are a few more things to consider. Here are the pros and cons of being a corporation:

Pros

  • Liability protection – protect your company assets. Creating a corporation separates your business from your personal life. This helps prevent individuals from gaining access to your personal assets when they sue your company. If you are concerned about the specifics of liability protection, it’s a good idea to sit down with a lawyer and go through these options.
  • Unlimited shareholders – fund your start-up with as many investors as you please. If you are planning on raising capital from multiple sources, corporations allow flexibility with different share classes. Just keep in mind that if you choose to be taxed as an s-corporation, you will not be able to maintain different share classes. More on this later.

Cons

  • Corporate taxes – the income your company earns is taxed at the corporate-level. This means that you file a corporate tax return each year and pay in taxes from the corporation. If you are a small company with one or a few owners, this is not ideal because the money paid in for corporate taxes is money the owners will never see personally. This creates incentives for small corporations to pay large salaries to themselves in order to minimize the corporate-level income taxes. However, they end up paying additional money in social security and Medicare taxes on the salaries, and also drain the company of funds they would like to keep in the business to operate.
  • Double-taxation – this is probably a term you have heard before. This is what happens when corporations pay dividends to their owners. The income is taxed at the corporate level as described above. Then, the dividends/profit distributions paid to owners are taxed again on the owners’ personal tax returns. This is the whole reason smaller corporations end up paying large salaries to their owners. It is the only way to get money out of a corporation without it being taxed twice.
  • Paperwork – annual report filings, annual tax returns, corporate minute books, etc. These are all things that you’ll likely have to pay lawyers and accountants to maintain for you, which can be costly.

Corporations make the most sense for larger companies with many shareholders. This organizational structure can make sense for small companies, however, if you elect to be treated as an s-corporation, which will be explained in further detail later.

LLCs

Limited liability companies are becoming more common, especially for small businesses. Here are the pros and cons of LLCs:

Pros

  • Liability protection – basically the same points listed above for corporations. Protect your company assets from business creditors and lawsuits.
  • Simplicity – LLCs are relatively easy to set up and maintain in most states. There are still annual report filings, but these are generally cheap and easy to file. If you are a single-member LLC, you will not need a separate business tax return. The income flows through to your personal tax return just the same as it would for a sole-proprietor.

Cons

  • Self-employment taxes – these are the same taxes referenced above under sole proprietorships. Many people think that forming an LLC alone saves taxes when compared to a sole-proprietorship. This is not the case unless you file an election to be treated as an s-corporation, which is discussed below.
  • Professional fees – involvement of lawyers and accountants is usually a good idea when you have an LLC. Lawyers will help you get set up in your state and form an operating agreement. Accountants are required when you have more than one LLC member. If there are multiple LLC members, you will be required to file a separate tax return for the LLC. The income still flows through to your personal tax return and is subject to self-employment taxes, but you need to report the income and expenses on a separate tax return, which costs money.

Single member LLCs make sense for sole-proprietors that have net income ranging from $10,000 to about $40,000 and are concerned about liability protection. They may also make sense for partnerships. However, I would generally not recommend forming one for a husband/wife partnership with equal ownership, as it creates unnecessary tax filings that cost money. It makes more sense to operate as sole-proprietors or have one spouse own 100% of the LLC.

When Do S-Corporations Make Sense?

S-corporations are formed by filing an s-election with the Internal Revenue Service. S-corporations are not legal entities, but rather just a change in tax structure for an existing legal entity, such as an LLC or a corporation. S-corporations make the most sense for companies with one shareholder that have net income of about $40,000 or more. There are significant tax savings to this election, but there are also additional professional fees required to operate and maintain an s-corporation. The tax savings start to outweigh the additional fees required once net income gets near the $40,000 range for most companies. If you are a sole-proprietor or single-member LLC owner and you are making more than $40,000 per year in net income, you are almost certainly paying too much in tax and it is time to consider the s-election. Here are the pros and cons of making this election:

Pros

  • Tax savings – this is basically the whole reason to make the s-election. S-corporations are not liable for any federal corporate income taxes on their net business income. Instead, the income flows through to the shareholders’ personal tax returns. However, unlike LLCs or sole-proprietorships, this net business income IS NOT SUBJECT TO SELF-EMPLOYMENT TAXES. It is only subject to income taxes, as with almost all other types of income in the United States.
  • Distributing income to owners – the nice thing about an s-corporation is that the owners can take what are called “sub-s distributions.” This is essentially a distribution of business profits to the owners that could be compared to a dividend. Unlike dividends, they are not taxed twice. All of the income earned by an s-corporation flows through to the owners’ personal tax returns and is subject to income taxes. This is true whether or not the profits are distributed to owners. As earnings accumulate in the company and cash balances increase, these accumulated earnings can be distributed to the owners without incurring any additional income taxes. The thought process behind this is that the income was already taxed when it was earned, so distributing the income should not impact an owner’s tax return.

Cons

  • Professional fees – accounting, tax preparation, payroll tax filings – all that fun stuff. When you are an owner of an s-corporation, the IRS requires that you take a “reasonable salary.” This is true even if there is one owner and no other employees. The IRS basically wants to make sure you are paying SOMETHING into social security and Medicare. Since the net business income isn’t subject to these taxes, the IRS has to prevent s-corporation owners from just distributing all profits to owners without incurring FICA taxes. In order to take a reasonable salary, s-corporations have to register for payroll and pay in payroll taxes, which creates quarterly filing requirements that are generally filed by accountants or payroll processors. There are also annual tax filings for s-corporations that are not required for sole-proprietorships or single-member LLC’s. This is why I generally do not recommend the s-election until the tax-savings outweigh these additional services required.
  • Multiple owner issues – things always seem to get more complicated with more people. If you have an s-corporation with multiple owners, your sub-s distributions, or profit distributions, need to be in line with your ownership percentages. So if you own an s-corporation 50/50 with someone else and you take a $1,000 profit distribution, the other owner needs to do the exact same thing. This is even true when you run personal expenses through your business bank account (which I never recommend doing ever). So if you spend $8.49 at McDonald’s and accidentally use your business card, your business partner also needs to take an $8.49 distribution. This can make things messy if your books are not clean.
  • Shareholder limitations – S-corporations can not have more than 100 shareholders. There are also limits as to what types of shareholders are allowed. For example, an s-corporation cannot be an owner of another s-corporation. This is not an issue that most small businesses run into, but can become one as your business grows.

Ever wonder why people pay accountants and lawyers so much money? It’s because these decisions are difficult and making the wrong decision can be very costly. For help with your decision, contact me for a consultation.

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