IRA Financial’s Adam Bergman discusses how to choose the right entity for your business. He talks about sole proprietorships, LLCs, S & C Corporations and the pros and cons of each.
Mr. Bergman’s latest podcast is specifically for small business owners and the self-employed in general. Moreover, it’s especially important for those who are looking into going into business for themselves. One of the first things you need to do is to choose the right entity for your business. A lot of factors goes into this decision including what type of business you have, how dedicated you are and where you live. Mr. Bergman discusses each type of entity and who it’s designed for.
Types of Business Entities
Let’s discuss the four most common business entities – sole proprietorship, Limited Liability Company (LLC), C Corporation and S Corporation.
A sole proprietorship is the most basic of business entities. Unlike corporations and LLCs, there is no need for a “separate legal entity.” Therefore, it’s perfect for owner-only businesses, contractors and consultants. The one drawback is the lack of protection. Profits from the business are reported on the owner’s tax return. Therefore, if your business suffers losses, you take the hit. Further, if your business folds, there is no protection afforded to you with other entities. However, if your business does thrive and you need to expand, it’s quite easy to restructure the business into an LLC or corporation.
A sole proprietorship is perfect for those that have a side-job or run a small business on his or her own. It’s not ideal for larger, more active business ventures. Further, the business/services you perform should be safe. You don’t want to take on something that might fail or risk getting hit with tons of losses when you file your taxes.
Limited Liability Company
An LLC differs from the sole proprietorship in that (as the name states) the owner(s) are not personally liable if the business fails. However, profits and losses from the business are reported on the owners’ personal tax return. An LLC can be created in any state as is generally not very expensive. Also, annual LLC fees are fairly inexpensive, depending where you live. Here in Florida, it’s $140 right now. However, if you live in California, you pay a minimum franchise fee of $800.
Mr. Bergman describes an LLC as a funnel. If something happens with the business, you are protected. No one will come after your house, you car or any of your belongings. Only the assets of the LLC can be touched. From a federal standpoint, the LLC does not pay tax. Each owner of the LLC is responsible for the taxes accrued through the business.
LLCs can be single member (meaning one person) or multiple member (two or more people). It might be more beneficial to take on a partner in your state. For example, in Florida, a multiple member LLC is afforded better creditor protection than a single member.
What makes a C Corporation different is how it’s taxed. The business is first taxed on the corporate level. Earnings are then sent to the shareholders in the form of dividends. These dividends are then taxed on the shareholders’ personal income tax return.
What makes a C Corporation a good option is the actual corporate tax rate. Thanks to the Tax Cuts and Jobs Act, the tax rate is at 21%, down from 35%. This makes it very advantageous for those who are in a high tax bracket and use an LLC. Instead, they can pay the lower rate by switching their company to a C Corporation.
Lastly, C Corporations must have an annual meeting for shareholders. Moreover, they have a board of directors that are voted on by the shareholders. The stocks of the corporation can be sold to bring in more capital to grow the business. The business can carry on even as owners change.
Lastly, there is the S Corporation. Unlike a C Corp, the S Corporation is not taxed on the corporate level. Instead, similar to an LLC, the taxes are paid on a personal level. Therefore, there is no double taxation. Essentially, an S Corp can be created when you have less than 100 shareholders and can be treated like a partnership.
To avoid misuse, S Corps are heavily scrutinized. Owners must take a reasonable salary based on the profits of the business. Therefore, you cannot pay yourself a lower salary to avoid taxes.
Chose the Right Entity for Your Business
List above are the four main types for you to choose the right entity for your business. Each one has their own advantages and are designed for particular needs. Sole proprietorships are perfect for those that have a side business that earns some income. LLCs are a low cost way that offers personal protection from business losses. C Corporations are for larger businesses. Capital can be generated from the sale of stocks. S Corporations avoid the corporate tax rate, but can be more cumbersome to utilize.
Laws, fees, taxes and creditor protection vary from state to state. Generally, it’s best to create your business in the state you reside in. Doing otherwise might cast the spotlight on your goings on. In the end, you’ll pay what you owe both where you live and the state your business was created. We’ll talk more about this in a future podcast!
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