If you are one of the millions of people who have made the decision to go into business for yourself during the last five years, congratulations! Hundreds of thousands, even millions of people, have figured out that the best way to economic stability and freedom is to become your own boss, master of your own destiny.
Choosing the correct business structure is one of the critical issues involved in starting your business off on the right foot. For some people, depending on what their business involves, it’s a no-brainer, but for many, the issue is complicated and can have lasting impact if they make a mistake.
A sole proprietorship is the easiest kind of business to begin. It generally starts out as a single person working on their own, but it can also involve several people. You may be working under your own name, perhaps as a consultant, or you may have obtained a DBA (Doing Business As, a legal name that you have registered for your business, separate from your own personal name) from your local jurisdiction.
The main problem with such a business is that you, as owner/operator, have no legal protection should things go bad. Business creditors can claim your personal assets if your business fails to pay its debts. Or if, for example, you accidentally injure someone during the course of doing business, you are personally responsible and can be sued for everything you own. And even if your business does not involve anything that could possibly harm a customer physically, you are completely open to breach of duty, negligence, or other types of lawsuits that could potentially ruin your life.
Additionally, with a sole proprietorship, all of your income flows down to your personal income tax forms, and you will have to pay self-employment taxes on that income. Self-employment taxes means that you must pay the entire amount of the Social Security and Medicare taxes; these are generally split with the employer when people are not self-employed.
A limited liability company is the “next step up” the business-structure ladder. It is not much more complicated to set up than a sole proprietorship, sometimes consisting of only a single-page form to be filed, and affords several benefits that make it worth considering, no matter how small your business.
Firstly, and most importantly, it separates your personal from your business assets, and offers legal protection of your personal assets. The company is now a completely separate entity from the owner or owners, and no individual liability can be extended to the owners. Business creditors cannot take your personal assets. And if something happens within your business dealings, any lawsuits filed can only go after your business assets; no one can pursue your personal assets.
Tax-wise, limited liability companies are not taxed at the company level; all income is passed through to the owners, who declare it on their personal tax returns. If you are the sole owner of an LLC, you will not even have to file a company return; merely note the information on your personal return.
LLC income, because of the way it is “passed through” to the owners, does incur the full amount of the self-employment taxes that are also incurred by a sole proprietor.
An S-corporation is a legal business entity that is more like what you would consider a “big company”. It’s less cumbersome to set up and maintain than an ordinary “C-corporation” but it does offer many of the same advantages.
On the paperwork side, an S-corporation does come with a number of requirements that must be met, and should be set up with the help of a legal expert as it can be somewhat more complicated than setting up an LLC. For example, bylines must be drafted and adopted, stock must be issued, and annual meetings must be held. Strict guidelines must be met in the running of the company, as well, or the S-corporation designation can be disallowed.
Legally, of course, the structure includes the full separation of business and personal assets. There is no owner liability in terms of debt, or in terms of legal responsibility, for any actions undertaken by the business. (Except in certain cases of gross misconduct or neglect, that is, but not under ordinary circumstances.)
The main advantage to the S-Corp structure for a small business owner is in the way that income is distributed and taxed. An S-corporation pays its owners and employees a “reasonable” salary, on which the company pays half of the “employment taxes”, and the employee pays the other half. The employment taxes paid by the company are tax-deductible as a company expense, and reduce the amount that the company declares as income. (This income is not taxed at the corporate level on Federal income tax returns, but may be taxed on state returns depending on where the company is located.)
The owners then report this salary on their individual income tax return, and pay the commensurate taxes on it. However, any additional income that the company then chooses to pay out after expenses have been met, can be distributed to the owners as “dividends” rather than as ordinary income, and will be taxed at a lower rate on the owners’ individual returns.
So there are a number of issues to consider when choosing how to structure your new business:
Please discuss your options with an experienced legal or tax expert before choosing your structure. It is not easy to change from one to another if you choose incorrectly initially.
Brad Hanks is in charge of Growth at ZipBooks.