You can operate your business as a Sole Proprietor, like 70% of US businesses. However, if the business has to get great and you’re starting to get some serious cash, then it might be wise to include, as a method to lower your taxes and protect profits.
You may be implementing a growth strategy that requires you to take in additional investors, or you may be implementing your exit strategy, with plans to sell your business, perhaps to employees through an Employee Stock Option Plan (ESOP). Either scenario may require your accountant or business attorney to recommend that you establish separate legal entities and the preferred strategy is to combine them.
What does that mean in practical terms? For solopreneur consultants or small business owners, joining usually means establishing an S Corporation. A Limited Liability Company (LLC) is another legal entity that is often used and there are certain similarities between the two.
Both LLCs and S Corporations provide business owners with a level of protection from lawsuits and creditors. However if negligence is involved, the “corporate veil” of protection will be breached and the owner will be liable for any damages.
Second, there are certain similarities in the way taxes are handled. LLCs and S Corporations, unlike the more common C Corporations, allow “passing” business profits or losses to the owner’s (S Corporation’s shareholders) personal tax Form 1040 according to the share of ownership. There is no separate (double) tax, as is the case with C Corporations. Owners of S Corporations and LLCs can deduct pre-tax business expenses such as advertising, professional services, travel, etc. S Corp owners will file Form 1040 Schedule E and Form 1120S in addition to the usual state and federal tax forms.
However, there are some differences that have an impact on tax treatment. Unlike an LLC and like a C Corporation, the owners of an S Corporation pay themselves a salary (which should be considered reasonable by industry standards and business income) and they receive a dividend (distribution) of any additional profits earned. Dividends are taxed at a lower rate than payroll and that is one reason the S Corporation’s tax rate may be lower.
Another difference involves the self-employment tax. Says Diane Kennedy, Phoenix, AZ based CPA and author of “Loophole of the Rich: How the Rich Legally Make More Money and Pay Less Tax” (2001), “If you have an S Corporation Subchapter and you put yourself on the payroll as a W-2 employee, withholding taxes from each paycheck when you take money from the company, you can often save a significant amount of money in self-employment taxes.” Sole proprietors and LLC owners must pay self-employment tax.
Owners can sell, transfer, or gift their shares, something LLC owners cannot. There can be no more than 100 shareholders/owners of S Corporation, but family members who own shares are treated as one shareholder when counting. Subsequent corporations, subchapter C or S, continue indefinitely unless formally disbanded. Death does not automatically dissolve the company, while an LLC terminates if one of the owners retires, resigns, dies or goes bankrupt, but can be reformed if desired.
On the downside, S Corporations have stricter guidelines than LLCs. Owner must be a US citizen or reside in the US. There is only one class of stock and depending on the state you are in, there may be additional state taxes. Businesses that earn 25% or more of gross income from passive income (eg rental income) and those that receive 95% or more of gross income from exports are prevented from forming an S Corporation.
Owners of S Corporations must also hold annual meetings of the board of directors and shareholders and keep minutes. Furthermore, the owner must strictly separate personal and corporate bank accounts. Failure to comply with all requirements may result in confiscation of S Corporation status and the IRS seeking.
So which legal entity is best for your organization? Throughout the life of your business, it is wise to reflect on your plans for the future in terms of income, growth, exit strategies and taxes and institute legal structures that will enhance your position.
Thanks for reading,
Kim