Do you remember as a kid having a lemonade stand? It seemed so simple to sell lemonade. All that you needed was a sign, customers, and lemonade, right? As a kid, you didn’t think about how the customers were going to hear about your business (marketing), where you are going to get money to make the lemonade (financing), or what happens when you run out of lemonade (replenishment/ production). Your one vision was to earn enough money to buy your favorite toy not on choosing the right business entity structure. This vision guided you to want more than just the success of a lemonade stand as an adult.
There is much more to consider when starting up your business now as an adult. Finding the right entity is like finding the right pitcher to make the lemonade. It can’t be too big or too small, it must be just right.
When choosing between the different entity types, consider one of the following structures: a sole proprietorship or partnership (the default choices if you do not formally organize), a corporation, or a limited liability company (LLC). We left out the S-corporation, B-corporation, public-benefit corporation or nonprofit, and trusts from this list because the former are all types of corporations, and while the latter can be an owner of an entity, it is not the entity itself. There are several options to choose from for a variety of reasons, but what is the best way for YOUR new business? Finding the right fit for your future business can affect your taxes, payroll, and personal liability just to name a few reasons. Here are some key factors to consider when starting your own company.
1. How Many Owners Does Your Company Have?
The number of owners in the business can affect the entity structure available to you. If you are the sole owner of the business you can operate by yourself then an LLC, sole proprietorship, or corporation might be a good option for your business. The owners of an LLC are called “members” and you would operate as a single-member LLC. If you choose a corporation, the owners are “shareholders,” and you would be the sole shareholder of your corporation. Of course, if you just open the doors or launch the website, you can operate as a sole proprietorship.
Now, if your business has more than one owner your entity could be a partnership, corporation, or multi-member LLC. It is imperative to keep in mind that if you have more than one member it means more than one opinion that is brought to the table. Multiple ideas are not necessarily a bad thing, but make sure that you have an operating agreement or bylaws that have been created and reviewed by a lawyer. If you use a DIY website, then you will probably pay the price (literally & figuratively) in the long run. A DIY site document might overlook some key sticking points which could end up in conflict once it is too late. The errors are usually discovered once the fight has begun, and then it is too late.
It is not easy to try and maneuver through business issues, such as ownership terms, transfer rights, what happens when a member or shareholder wants out, and what happens upon the death of an owner, all of which require serious consideration.
We can quickly refer to these challenges as the 5 Ds:
Each involves decisions that simply cannot be addressed with a one-size-fits-all template document. Attempting to “do it yourself” brings the risk of having some surprises down the road with trying to sell your business, raise capital, or what if one of the owners is incapacitated? What happens to the business if an online site helped to create your entity structure? Who can you turn to then? Finding the right lawyer to help you to create the path to success is imperative at the beginning of your business. At Yolofsky Law, we are there with you every step of the way on your journey.
2. How Much Personal Liability Are You Willing to Face?
As a business owner, it is a matter of time before legal services will need to render for one reason or another. In today’s society, a company can get sued for the coffee being too hot, which leads to a wholesale change of industry standards. What if your business and personal life were intertwined? You then run the risk of possibly your business getting sued and then losing your house, your car, and maybe even your entire life savings due to operating your business in the wrong entity.
What if your business unexpectedly faces an unforeseen event, like COVID, health issues, or market changes? Without the proper entity in place for business, creditors could try and seize your personal assets to satisfy your business debts. This risk arises because, without the correct entity in place, there’s no separation between your business and personal assets, so your personal assets could be up for grabs in the event your company ever gets sued or goes into serious debt.
If you set up your business as an LLC or a corporation and maintain the corporate formalities of these entities, you can better safeguard your personal assets from your company’s legal liabilities, including lawsuits and debt. These two structures establish your company as a separate legal entity that’s distinct from you and the other owners as individuals, keeping you safe from being held personally liable for the company’s debt or legal judgments as long as they are properly maintained.
3. How Would You Prefer to Be Taxed?
We all want to pay fewer taxes and gain more benefits. Like your liability exposure, your choice of entity also dictates how your business is taxed. If your business is a sole proprietorship or a partnership, you and the other owners are legally the same as your business, so your share of the company’s profits or losses are reported on your personal income tax return and taxed at your personal income tax rate. Sometimes, it is best to keep personal and professional separate from a tax perspective.
On the other hand, as a C-corporation, your business is considered a separate legal entity from you and the other owners for both liability and taxation purposes. As a result, the corporation pays taxes at the new flat corporate tax rate of 21% established by the Tax Cuts and Jobs Act of 2017. Then, after-tax profits are distributed to the shareholders, and those profits are taxed at the personal rate of each of the shareholders. This system of “double taxation” means the corporation first pays tax at its rate, and then the shareholders pay tax at their own individual tax rates. This shouldn’t automatically disqualify C-corporations as an option for your business. Indeed, depending on your specific goals, a C-corporation might be exactly what’s needed.
As an LLC, you have flexibility in choosing how you’ll be taxed. Unless you choose to be taxed as a corporation, single-member LLCs are automatically taxed as sole proprietorships (or a “disregarded entity” in IRS parlance), while multi-member LLCs are taxed as partnerships. In either case, your company doesn’t pay any taxes on its profits itself. Instead, your share of the net business income is taxed on your personal tax return, and you’ll pay taxes based on your personal income tax rate.
Of course, no discussion of entity taxation basics is complete without a reference to the S corporation. The main advantage of choosing to be taxed as an S-corporation is that you only pay payroll taxes on your payroll, not on your profit distributions from the company. Whereas, if you are taxed as a sole proprietorship, all profits are considered payroll and subject to payroll taxes. In addition, the audit risk for S-corporations is typically less than the audit risk for companies taxed as sole proprietors, where income and expenses are reported on your personal Schedule C.
If your business is taxed as an S-corporation, you will pay income taxes on your profit distributions, but you would save roughly 15% in payroll taxes on distributions taken as profits, rather than as payroll since you don’t pay payroll taxes on income taken as a profit distribution. In contrast, when using an LLC taxed as a partnership or sole proprietorship, you will pay payroll taxes on all distributions to you from the LLC up to the payroll tax limits.
That said, for an S-corporation election to make sense, you’ll want to have at least $60,000 or so of net income per year. If you are close to that amount and have not yet filed an S-corporation election, be in touch with us, so we can help make you a hero to your family and business.
One Size Does Not Fit ALL
With so many different types of entities to set up your business that can lead to your success and hopefully not failure. This decision will affect the taxes you pay, the types of records that need to be kept as well as your personal liability. It is not one size fits all. We are here to help you find the right entity for your business and help your business prosper along the way, call us at (305) 702-8250 or email us at firstname.lastname@example.org.