You can operate your business as a sole proprietor, like 70% of American businesses. However, if the business turns out to be terrific and you begin to earn a lot of cash, then it may be worth incorporating it, as a method of reducing your taxes and protecting profits.
You may be implementing a growth strategy that requires you to take on additional investors, or perhaps implementing your exit strategy, with a plan to sell your business, perhaps to employees through an Employee Stock Option Plan (ESOP). ). Either scenario may cause your accountant or business lawyer to recommend that you establish a separate legal entity and the preferred strategy might be to incorporate it.
What does that mean in practical terms? For a Solopreneur consultant or small business owner, incorporation typically means establishing an S Corporation. A Limited Liability Company (LLC) is another frequently used legal business entity and there are certain similarities between the two.
Both LLCs and S corporations provide business owners with a degree of protection against lawsuits and creditors. However, if there is negligence, the “corporate veil” of protection will be torn and the owners 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 a “passthrough” of business profits or losses to the owner’s Personal Tax Form 1040 (the S Corporation shareholders) based on ownership interest. property. There is no separate (double) taxation, as is the case with C Corporations. Both S Corporation and LLC owners 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 a couple of differences that affect the treatment of taxes. Unlike the LLC and like the C Corporation, the owners of the S Corporation pay themselves a salary (which should be considered reasonable based on industry standards and business income) and receive dividends (distributions) from the additional earnings earned. Dividends are taxed at a lower rate than the salary payment and that is one of the reasons why S Corporation tax rates may be lower.
Another difference has to do with taxes on self-employment. Says Diane Kennedy, a Phoenix, AZ-based CPA and author of “Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax” (2001), “If you have a Subchapter S Corporation and you put yourself on the payroll as A W-2 employee, by withholding taxes from each paycheck as they withdraw money from the corporation, can often save a significant amount of money in self-employment taxes.” Sole proprietors and LLC owners must pay self-employment taxes.
Owners can sell, transfer or give away their shares, something LLC owners cannot do. 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. Other corporations, subchapter C or S, continue in perpetuity unless formally dissolved. Death does not automatically dissolve a corporation, while LLCs terminate if an owner retires, resigns, dies, or goes bankrupt, but they can be reformed if desired.
On the downside, S corporations have stricter guidelines than LLCs. Owners must be US citizens or reside in the US There can only be one class of shares and, depending on the state in which it was incorporated, there may be additional state taxes. Businesses that earn 25% or more of gross receipts from passive income (eg, rental income) and those that earn 95% or more of gross receipts from exports cannot form an S Corporation.
S corporation owners must also hold annual board and shareholder meetings and take minutes. Additionally, owners must strictly separate their personal and corporate bank accounts. Failure to comply with all requirements may result in loss of S Corporation status and the IRS is investigating.
So which legal entity is best for your organization? Throughout the life of your business, it is wise to look at your plans for the future in terms of revenue, growth, exit strategy, and taxes, and institute the legal structure that will enhance your position.
Thank you for reading,
Kim