You may operate your business as a Sole Proprietor, like 70% of US businesses. However, if business should become fabulous and you begin to rake in some serious cash, then it could be wise to incorporate, as a method to lower your taxes and protect profits.
You may be implementing a growth strategy that requires you to take on additional investors, or maybe implementing your exit strategy, with a plan to sell your business, perhaps to employees through an Employee Stock Option Plan (ESOP). Either scenario may prompt your accountant or business attorney to recommend that you establish a separate legal entity and the preferred strategy could be to incorporate.
What does that mean in practical terms? For a Solopreneur consultant or small business owner, incorporating usually means setting up 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 from lawsuits and creditors.Yet if negligence is involved, the “corporate veil” of protection will be pierced and owner(s) will be liable for any damages.
Second, there are certain similarities in how taxes are handled. LLCs and S Corporations, unlike the more common C Corporations, allow a “pass through” of business profits or losses to the owner’s (the S Corporation shareholders) personal tax Form 1040 in accordance with the share of ownership. There is no separate (double) taxation, as occurs 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.
There are however a couple of differences that impact the treatment of taxes. Unlike the LLC and like the C Corporation, S Corporation owners pay themselves a salary (that must be deemed reasonable based on industry standards and business revenue) and they receive dividends (distributions) from any additional profits earned. Dividends are taxed at a lower rate than the salary pay-out and that is one reason that S Corporation tax rates may be lower.
Another difference involves self-employment taxes. Says Diane Kennedy, 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, withholding taxes from each paycheck as you take money out of the corporation, you can often save a significant amount of money in self-employment taxes”. Sole proprietors and LLC owners must pay self-employment taxes.
Owners may sell, transfer or gift their shares, something that cannot be done by LLC owners. There cannot be more than 100 S Corporation shareholder/owners, but family members who own shares are treated as one shareholder when counting. Further corporations, subchapter C or S, continue on in perpetuity unless formally dissolved. Death does not automatically dissolve a corporation, while LLCs terminate if one owner retires, resigns, dies or goes bankrupt, but can be reformed if desired.
On the downside, S Corporations have more stringent guidelines than do LLCs. Owners must be US citizens or reside in the US. There can be only one class of stock and depending on the state in which you’ve incorporated, there may be additional state taxes. Businesses that derive 25% or more gross income from passive income (e.g. rental income) and those who receive 95% or more gross income from exports are prevented from forming an S Corporation.
S Corporations owners must also hold annual board of directors and shareholder meetings and take minutes. Further, owners must strictly separate their personal and corporate bank accounts. Failure to adhere to all requirements may result in forfeiture of S Corporation status and the IRS is looking.
So which legal entity is best for your organization? Throughout the life of your venture, it is wise to contemplate your plans for the future in terms of revenue, growth, exit strategy and taxes and institute the legal structure that will enhance your position.
Thanks for reading,