As a new small business owner, you are barraged with important decisions around banking, payments, and every other aspect of your business. One of the most important decisions you will make is how to structure your business. This decision can have monumental tax and legal implications down the road, and making the right decision today can save you a lot of headache tomorrow.
When starting a new business, all business owners are categorized as a “sole proprietorship” by default. This means you are doing business as yourself under your own name. Any time you make money or operate a business venture without filing as a business entity with your state, you are a sole proprietor.
Sole proprietorships are easy and simple to operate, but offer no legal, financial, or tax benefits to you as a business owner. If someone sues you, they can go after your personal assets, like your personal savings and home, for financial restitution.
Limited Liability Company
The next logical progression, and a very popular option among freelancers and other small businesses, is a limited liability company or LLC. An LLC offers the same tax structure as a sole proprietorship for most LLCs with a single owner, but there are some big legal benefits that a sole proprietorship doesn’t offer.
An LLC is its own legal business entity, so if someone sues an LLC, they are not suing the owner directly. If the owner keeps proper financial records and maintains a separation between personal and business financial accounts, personal assets are kept safe from the lawsuit in most situations.
The cost of filing an LLC varies dramatically from state-to-state. For example, in Colorado creating an LLC costs $50 and then $10 per year to maintain your registration. In California, however, filing fees plus the state’s franchise tax subject each new business to nearly $1,000 in fees even if you don’t earn a profit.
If you are working for yourself full-time, a sole proprietorship or LLC may lead to you paying more taxes than you have to. Because your earnings under those structures treat you as both the employee and the owner, you pay self-employment taxes on every dollar you earn.
Up to around $40,000 per year in income (this depends on your state, contact a local tax expert if in doubt or if you have any questions), there is no major tax benefit of filing as anything other than an LLC. Over $40,000, that changes.
S-Corporations, commonly referred to as an S-Corp, offer tax benefits to businesses with that level of income or higher. Here’s how it works:
- As a sole proprietorship or single member LLC, you pay 15.3% in self-employment taxes up to $118,500 in income. This includes social security and Medicare. Over $118,500, you pay 2.9%.
- As an S-Corporation, you are an employee of the corporation, so you only pay self-employment tax on your salary, not your total income. The IRS requires you to pay yourself a “reasonable” salary for your job.
- Any earnings above your salary are only subject to regular income tax, not self-employment tax.
That’s where that “around $40,000” comes in, as that is a “reasonable salary” for many jobs. However, filing and maintaining an S-Corp comes with many additional requirements and some additional costs, so it is not ideal in all situations.
LLC Taxed as an S-Corp
Now here’s the big curveball. An LLC can be taxed as an S-Corp! This option is typically best for someone who has an existing LLC and is earning enough that they want to take advantage of S-Corp tax code without the legal implications of filing as an S-Corp.
It is kind of like the best of both worlds.
Make an Informed Decision
As a small business owner, you have to make lots of inconsequential decisions. This is not one of them! Deciding how to structure your business and file your taxes has major legal and financial consequences, so make an informed decision when deciding how to file your business forms.
If you’re in doubt, consult a small business attorney or tax expert to help you out. This is too big of a decision to leave up to chance, and one you certainly don’t want to make incorrectly.