Choosing the Right Structure – Inside INdiana Business
Starting your own business is not for the faint of heart. One item that causes a lot of consternation is how to structure your new business from a legal and tax perspective. Here are some of the most common types of business entities, along with the pros and cons of each.
Entity Options – Which Should I Choose?
Individual business. The most common and least complex structure is the sole proprietorship. The ‘sole proprietor’ is suitable for companies with only one owner. They’re easy to set up (you can use your social security number as your business ID), cost little or nothing to set up, and don’t require a separate tax return. As the sole proprietor, you have full control of the business and retain all profits.
Partnerships. Partnerships share similar characteristics to sole partners in that they are easy to administer and inexpensive to create. They also provide flexibility with regard to business income, as the distribution of profits does not need to be managed proportionally. This is advantageous in cases where a silent partner (one who provides capital but is not involved in the day-to-day) is a key member of the business. Sole Proprietorship and Partnerships are both considered “transparent” structures because the net income recognized by the corporation is taxed on the owners’ tax return and not at the corporate level. While both entities have advantages, there are glaring disadvantages.
- Neither entity provides personal liability protection. This implies that the owners and the company are one. Thus, the personal property of the owner(s) is not protected from creditors.
- Raising capital is also a difficult business. You can’t sell stocks to raise cash, and banks are often hesitant to lend to these types of small businesses.
- Another major downside is the FICA taxes which include taxes for Social Security and Medicare. Net profits (less the deductible portion of self-employment taxes) will be taxed at 15.3% (12.4% for SS up to IRS limits; 2.9% for Medicare).
S corporation. What options are available if you want liability protection and a unique tax transfer structure? Enter the S-Corp (it is important to recognize that an S-Corp, unlike sole proprietors and partnerships, is NOT a business structure, it is a tax election).
- Once you have filed as a corporation (by default, all corporations are C-Corps), you must apply for S-Corp status with the IRS to establish this election.
- An S-Corp provides that protective barrier that isolates all business debts to your business itself and isolates personal assets.
- Additionally, as an S-Corp, you are technically an employee-owner, which means the compensation you receive can take two forms: salary and net income distributions. Why is this important? As noted above, all net income from unique props and partnerships is subject to FICA. With an S-Corp, only the salary you pay yourself is subject to FICA.
For example, Joe’s Tacos (a single accessory) has a net income of $100,000, which is taxable income for him. In conjunction with these taxes, his self-employment taxes will be $14,130 ($100,000 net income less the deductible portion of self-employment tax (7.65%) x (15.3% )). Conversely, if Joe is an S-Corp, he could pay himself a salary of $60,000. As an S-Corp, Joe only has to pay FICA taxes on his salary, which is $9,180. The remaining $40,000 of profits would only be subject to income tax.
So why not just choose S-Corp status and take ALL the income as distributions? Well, the IRS sticks to this strategy and has determined that you have to pay yourself a “reasonable wage” (what you would pay if you hired someone for the same position) in order not to use the S-Corp as a solution. circumvention to avoid tax.
Although the S-Corp has many positive attributes, it does come with its share of drawbacks:
- S-Corps require a fully legal setup, which adds cost as you will usually need the services of a lawyer and an accountant.
- Additionally, profits and distributions must be split according to ownership, removing some of the flexibility of the partnership.
- There cannot be more than 100 shareholders, all of whom must be US citizens or legal residents.
- You can also only have one stock class. Thus, there can be no preferred shareholders.
Limited liability company. The LLC (Limited Liability Company) is a kind of hybrid as it offers the ease of establishment and maintenance similar to sole proprietorships and partnerships while providing personal liability protection comparable to an S-Corp.
- The LLC is a legal entity only, which means it is not a taxable business structure, and you can choose the tax regime that suits your business. By default, single-member LLCs follow the sole proprietorship tax structure, while multi-member LLCs mirror partnerships.
- You can also choose to be taxed as an S-Corp for your LLC. Remember that an S-Corp is simply a tax election. This means it can provide additional flexibility on payment structure and subsequent taxation.
Deciding on how to structure your business can be a daunting process. If this process becomes too cumbersome, consider talking to your financial advisor for advice and hiring a lawyer if necessary. Taking the time to work out the pros and cons of each structure can yield better results for your business.
Mathew Ryan, MBA, CFP, EA is a Financial Planning Specialist at Bedel Financial Consulting, Inc., an Indianapolis-based wealth management firm. For more information, visit their website at www.bedelfinancial.com or email Mathew at [email protected]