Creating your own small business is a huge endeavor, which comes with a number of important decisions. One of the most important decisions you’ll need to make is how you structure your business.
This choice will have major legal and tax implications down the road. Choosing between a sole proprietorship, LLC, and S Corp for your company’s structure is not something you should take lightly. These are three common structures for small businesses — and each one has its own advantages and disadvantages. Here’s a rundown of all three to help you decide which is best for your business.
When you first start your business, you are legally considered a sole proprietorship until you structure yourself otherwise. As a sole proprietorship, you are doing business under your own name.
Because there is no separation between the owner and the business, your personal assets are lumped together with your business assets. The advantage is that the business’ assets also become your own. The disadvantage is that if someone sues you, he/she can go after your personal savings and property in addition to your business money.
Many people stay as sole proprietorships because it’s simple and cheap. You essentially don’t have to do anything to structure your business this way since it’s the default.
Sole proprietorships are great for people who have a hobby that makes them money. For example, if you sell crafts on Etsy as a side business, staying as a sole proprietorship may be just what you need.
In this business structure, you won’t have to file a separate tax return. Your business income and expenses are reported on your personal tax return with any other income you receive from other jobs and any other expenses you acquire. You pay a similar tax rate to what you pay on taxes from an employer. You’ll just pay an additional self-employment tax on the income from your business.
Once your small business reaches a higher level of revenue, you’ll want to structure your business in a way that protects you more than a sole proprietorship does. The next logical progression is a Limited Liability Company, or LLC.
This option offers the same tax implications as a sole proprietorship but comes with a major legal benefit. Since an LLC is its own business entity, your personal savings and property are protected (subject to some exceptions) in the event that someone decides to sue your company. Of course, you’ll have to accurately keep your business finances separate from your personal finances in order to properly protect your personal assets.
Structuring your business as an LLC comes at a cost. The price tag on the filing fee varies from state to state, and can also involve the cost of using a legal service if you’re not comfortable setting it all up on your own. For example, the filing fee to form an LLC in New York is $200 while the same process costs only $90 in Indiana, and then the same process only costs $70 in California.
An S Corporation is the most difficult and expensive business structure to form of the three. Given this, you may wonder why a small business owner would decide to structure his/her business as an S Corp. The answer is because there can be tax advantage to being an S Corp.
Unlike a sole proprietorship or an LLC, S Corps do not pay taxes on all revenue of the business. As an S Corp, you only pay taxes on the salary you decide to give yourself. The IRS requires you to pay yourself a “reasonable” salary for the work you perform.
Let’s say your business generates $100,000 in a year. As a sole proprietorship or LLC, you’d have to pay self-employment taxes on all of that revenue. If your business is structured as an S Corp and you give yourself a salary of $50,000 (which is reasonable for most work performed), you’d only have to pay self-employment taxes on that $50,000. The other $50,000 only requires payment of regular taxes. You would, however, be required to pay payroll taxes.
As you can see, the more your business grows, the more attractive an S Corp structure will be financially.
Of course, the issues are complex so it’s critical that you consult with tax and legal experts before making any decisions.
LLC Taxed as an S Corp
There is one more option for small businesses: an LLC taxed as an S Corp. This gives you the best of both worlds. You get the liability protection and low cost of setup that comes with an LLC, while getting the tax advantages that come with an S Corp.
This structure requires a special IRS filing. This structure usually emerges when a small business owner has an existing structure as an LLC and begins to make a lot more money.
Creative Geniusess offers a step by step guide on how to do this HERE.
Which Is Best For Your Business?
To aid you in your decision, here’s a quick table that sums up the pros and cons of each structure:
|Sole Proprietorship||LLC||S Corp|
|Tax Advantages||Must pay self-employment tax on all income||Must pay self-employment tax on all income||Pay self-employment tax only on elected salary|
|Liability Protection||None||Personal assets are separate and protected||Personal assets are separate and protected|
A sole proprietorship is a good option for those who have a side hobby that earns them a little bit of money. It’s the default business structure if you don’t file any papers with the IRS. The main downside is that your personal assets are not protected in the event that someone decides to sue you. Also, you must pay self-employment tax on all of your income.
An LLC is a natural progression once your side hobby becomes more lucrative and transitions into an actual small business. There is a cost to structure your business as an LLC with the IRS; and that cost varies by state. The main advantage here is that your personal assets are separate and protected. Like a sole proprietorship, you are required to pay self-employment tax on all income generated by your business.
For those who are making decent revenue from their business, an S Corp may be the best option. This structure requires you to only pay self-employment tax on your elected salary, which must be “reasonable” according to the IRS. This can result in major savings depending on how much revenue your small business generates.
As previously mentioned, another option is to structure your business as an LLC and have it taxed as an S Corp. This gives you the benefit of protecting your personal assets and keeping IRS filing costs low while getting the tax advantages of an S Corp.
Which business structure you choose will depend on how much revenue your business is currently generating and how much revenue you expect it to generate in the future. No matter which structure you choose, you can always change it at the beginning of the next tax year.
If you need assistance in deciding which structure is best for your business or need help filing the papers with the IRS, it’s best to consult a tax expert or small business attorney.
As we said before, the issues are complex. It’s critical that you consult with tax and legal experts before making any decisions.