You can operate your business as a sole proprietor, like 70% of American businesses. However, if the business becomes terrific and you start earning a lot of cash, then it might be wise to incorporate 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 business accountant or lawyer to recommend that you set up 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 usually 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 from lawsuits and creditors. However, if there is negligence, the “corporate veil” of protection will be torn and 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 “roll over” of business profits or losses to the owner’s (the S Corporation’s stockholders) Personal Tax Form 1040 according to the share in the 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 regular 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 corporations. additional earnings earned. Dividends are taxed at a lower rate than 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, 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 money is withdrawn from the corporation, can often save a significant amount of money on 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 the S Corporation, but family members who own shares are treated as a single shareholder when counting. Other corporations, subchapter C or S, continue in perpetuity unless formally dissolved. Death does not automatically dissolve a corporation, while LLCs end if an owner retires, quits, 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 US residents. There can be only one class of shares and, depending on the state in which it is incorporated, there may be additional state taxes. Businesses that derive 25% or more of gross income from passive income (e.g. rental income) and those that receive 95% or more of gross income from exports cannot form an S Corporation.
S corporation owners are also required to hold annual board and shareholder meetings and take minutes. Additionally, owners must strictly separate their personal and corporate bank accounts. Failure to meet all requirements may result in loss of S Corporation status and is being investigated by the IRS.
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 put in place the legal structure that will improve your position.
Thank you for reading,
kim