Why Should I Care About My Business Entity Type?
So you’ve decided to strike out and pursue the American Dream and start your own business, congratulations! Before you get started though, there are some things to consider about the entity you choose and how the decision will affect your life down the road. Choosing the correct business entity to meet your needs and starting on the right foot helps protect your business and personal interests from a myriad of financial stressors. Allow me to illustrate this point, being in the heart of Coastal Virginia most people here are familiar with various nautical vessels, either commercial or naval.
Imagine you start off your business by going down to your local municipality and registering for a business license without any other legal preparation. This puts you in the ‘sole-proprietor’ (sole-prop) entity. A considerable number of first-time business owners do this, especially when they are a one-person show. In doing this you’ve essentially put yourself afloat in the ocean of business with a life-ring. That life-ring can keep you above water and can even assist you in moving from point A to point B, assuming the waters are calm and there are no sharks circling.
What happens though, when you hit a storm or there is even a hint of blood in the water. By that I mean you get into business, open a business checking account, create some credit relationships with vendors, and ultimately start making a profit. If the waters are smooth – everyone is paying you and you are paying everyone else – the life-ring can keep floating along.
Unfortunately, as happens in every business, there will come a time when a customer either cannot, or will not, pay the money they owe you. When this happens it may cause money to get tight. That storm may create a tidal wave your life-ring can’t help you stay above. If the business runs out of money before paying all the vendors you have to pay those vendors from your personal funds.
Additionally, let’s talk about that profit I mentioned earlier. A sole-props taxable profit is calculated as the money you collect less any valid expenses paid to other businesses or individuals. That means your pay isn’t deducted from the amount that gets taxed. Even if you are doing all the work for your company the IRS doesn’t consider you to be a tax deductible expense. ALL that profit is taxed at a special ‘self-employment’ rate. That self-employment is in addition to normal income tax, and guess who must pay that? You do, as the business owner, because in the eyes of the government your sole-prop isn’t a taxpayer.
Now let’s say you want more protection than that little life ring. Setting your business up as an LLC gives that added layer of security and peace of mind. The wonderful thing about setting up an LLC is the quick and straightforward process. I compare this to a sailboat, or RIB (Rigid-hulled Inflatable Boat for all our non-military readers).
LLCs are fairly easy to operate. Doing all your business in the name of the company keeps you away from the sharks. The downfall of these sailboats and RIBs is that they can be overpowered. In a perfect storm the LLC can capsize. This is known as ‘piercing the corporate veil.’ Basically, that is legalese for a time when an owner of an LLC has done something that goes outside the protections offered by the LLC. When you do you are now personally responsible. There are several situations where this can happen, so consult with an attorney about how to avoid this, should you choose to operate as an LLC.
Now from a tax stand-point, a simple LLC is still not considered a tax-paying entity. So your business falls under the same tax principles as a sole-prop. Meaning your work can’t be considered a tax-deductible expense, and you pay that self-employment tax on all the profit earned by the company.
If you want to get away from that tricky self-employment tax the way to do so is by forming a corporation. There are two types of corporations that are common here in the US, the C-Corp and the S-Corp. Both corporation structures allow a business owner to become an employee of the company. Therefore the owner is a tax-deductible expense, which is the primary reason there is no self-employment tax accessed on the earnings of these companies. However, that is another blog for another day.
I like to compare a C-Corp to a cargo ship or an aircraft carrier. These tend to be the largest ships around. They can carry a significant weight because they have a HUGE amount of power available to them. Some of the power a C-Corp offers to its owners is (in nearly all cases) total and complete separation from the operations and liabilities generated by the company. Additionally, a C-Corp can be owned by any number of entities, to include an unlimited number of individuals as well as other companies.
The C-Corp is viewed as a tax-paying entity in the eyes of the government, which means the company is responsible for its own taxes. This however, can be part of what makes a C-Corp very similar to a bulky ship like a cargo ship or carrier. Because the C-Corp pays its own taxes any money owners take from the company (beyond pay run through and taxed as payroll expenses) must be taxable income to the owner. This means that there is potential for these earnings to be taxed twice. One tax at the corporate level and one at the individual level.
I compare an S-Corp with a cruise ship or destroyer. These are more heavily constructed than an LLC, and offer amenities that an LLC or C-Corp cannot. The S-Corp is not a tax-paying entity. Therefore the earnings of the company are only taxed at the owner level. However, it does get the same advantage as a C-Corp in that there are no self-employment taxes imposed on those earnings.
The drawback here is that the S-Corp, like a cruise ship or destroyer, has a finite and much smaller amount of power than a C-Corp. There are very strict restrictions on who can own an S-Corp, and how the ownership rights are divided. Also, the S-Corp has additional regulatory filings and reporting that an LLC would not. This means they require more administrative support than an LLC.
There is another entity designation becoming increasingly popular for small business owners. Of late small businesses who are organized as an LLC can complete a form to make an S-Corp election. This means the business can be taxed as if it is an S-Corp, but it won’t be held to all the same restrictions as an official S-Corp. This election gives the company the luxury of a sporting yacht with the stealth of a submarine. There are still some critical compliance features that need to be adhered to for the election to remain effective. However, this election can be a hugely beneficial arrangement for small business owners who reach a certain threshold.
As with many other things in life, these entities are all merely tools available to business owners. There is no such thing as a one size fits all when it comes to tools. Knowing which ship is the right one for the business you want to start can be a complex decision. Also, your decision may not be a permanent one. Think of your average cruise, you may start out on one ship, but move to another as you approach a destination. Similarly you may elect to start with one entity and change to another as your business grows.
It is always best to consult an expert before jumping head first into the ocean of business and buying the biggest ship out there. Those of us here at Pixel Financial Group specialize in helping small business owners make these types of decisions. If you are thinking about starting your business we take a lot of care helping you evaluate your options. Not only do we help when you first start your company, but if you are worried you may have made the wrong decision we can help with that too.
For more information on your specific business situation and how your taxes could be affected by your business entity type click the ‘Contact Us’ button below and we will be happy to help you navigate.