Starting your own business is not for the faint of heart. One item that causes many surprises is how to structure a new business from a legal and tax perspective. Here are some of the more common types of business entities and their advantages and disadvantages.
Entity Options – What should I choose?
Sole proprietorship. The most common and simplest structure is the sole proprietorship. ‘sole-prop’ is tailored for a company with her one owner. It’s easy to set up (you can use your social security number as your business ID), costs little to set up, and doesn’t require separate tax forms. As a single owner, you have full control over the company and retain all interests.
partnership. Partnerships share similar traits as sole props in that they are easier to manage and cheaper to create. It also provides flexibility with respect to business income as the distribution of profits does not have to be treated on a pro-rata basis. This is useful when silent partners (partners who provide capital but are not involved in day-to-day operations) are key company members. Both sole props and partnerships are considered “pass-through” structures because the net income recognized by the company is taxed on the owner’s tax return rather than at the corporate level. Both entities have their strengths, but they also have some obvious drawbacks.
For consideration:
- Neither entity offers personal liability protection. This means that the owner and business are one and the same. Therefore, the owner’s personal assets are not protected from creditors.
- Fundraising is also difficult. Banks are often reluctant to lend to these small businesses, as they cannot raise money by selling stock.
- Another major drawback is the FICA tax, which consists of Social Security and Medicare taxes. Net income (minus the deductible portion of self-employment tax) is taxed at 15.3% (12.4% for SS up to IRS limits, 2.9% for Medicare).
S Corporation. What options do you have if you want a pass-through structure of liability protection and single taxation? It is important to recognize that it is a choice).
- Once you have applied as a corporation (by default, all corporations are C-Corps), you must apply to the IRS for S-Corp status to establish this election.
- An S-Corp provides a protective barrier that segregates all business liabilities to the business itself and isolates personal assets.
- Also, as an S-Corp, you are technically an owner and employee. In other words, the compensation you receive comes in two forms: salary and net profit sharing. why is this important? As noted above, all net profits from solo props and partnerships are subject to his FICA. With S-Corp, only the salary he pays is covered by his FICA.
For example, Joe’s Tacos (a sole proprietorship) has net income of $100,000, which is taxable income for him. Combined with these taxes, his self-employment tax would be his $14,130 (his $100,000 in net income minus the self-employment tax deductible portion (7.65%) x (15.3%)) . Conversely, if Joe is his S-Corp, he can make a $60,000 salary. As an S-Corp, Joe only needs to pay FICA taxes on his salary, which is $9,180. The rest of his $40,000 profit is subject to income tax only.
So why not opt for S-Corp status and take all income as a share? I decided that I needed to pay myself a reasonable salary (the amount you would pay if you hired someone else for the same position).
S-Corp has many strengths, but it also has weaknesses.
- S-Corps require a fully legal setup and typically require the services of a lawyer and accountant, which increases costs.
- In addition, profits and shares must be distributed according to ownership, making the partnership less flexible.
- The number of shareholders cannot exceed 100 and all must be US citizens or lawful residents.
- It is also possible to have only one class of inventory. Therefore, there are no preferred shareholders.
Limited Liability Company. A LLC (Limited Liability Company) is a kind of hybrid as it offers personal liability protection comparable to an S-Corp while offering the same ease of establishment and maintenance as a sole prop or a partnership.
- An LLC is a legal entity only, meaning it is not a tax-taxable business structure, allowing you to choose the tax regime that is right for your business. By default, a single-member LLC follows a single property tax structure, while a multi-member LLC reflects a partnership.
- You can also choose to be taxed as an LLC S-Corp. Remember that S-Corp is simply a tax option. This means we can offer more flexibility in payment structures and subsequent taxation.
Overview
Deciding how to structure your business can be a daunting process. If this process becomes cumbersome, talk to your financial adviser for their opinion, and if necessary, consider consulting an attorney. Taking the time to work through the advantages and disadvantages of each structure can yield better results for your business.
Mathew Ryan, MBA, CFP, EA is a Financial Planning Specialist at Bedel Financial Consulting, Inc., a wealth management firm in Indianapolis. For more information, please visit his website at www.bedelfinancial.com or email Mathew at mryan@bedelfinancial.com.