When starting a business, you have to make a ton of different decisions. From deciding what to name your company to hire employees, getting your business off the ground comes with a nearly endless number of decisions.
Of all these decisions, perhaps none is more important or has a more significant impact on your success (or failure) than your choice of business entity structure. The entity you choose for your business will affect everything contracted by your company. Your business entity will determine the amount of taxes you pay, what kind of records you keep, and how vulnerable your assets are to lawsuits.
Among the different business entities, all companies should be one of the following legal structures: a sole proprietorship, partnership, corporation, or limited liability company (LLC). Last week in part one, we discussed the first two of four leading factors to consider when selecting your entity, and here, we cover the final two.
Before making final decisions, consult with us, your Family Business Lawyer™. We will look at the factors below and help you find the entity that's best suited for your particular operation.
Similar to your liability exposure, your entity selection also dictates how your business will be taxed. Suppose your business entity is a sole proprietorship or a partnership. In that case, 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 income tax return and taxed at your personal income tax rate.
In contrast, 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 (TCJA). Then, after-tax profits are distributed to the shareholders. Those profits are taxed at the personal rate of each of the shareholders. This rate, “double taxation,” means the corporation pays tax at its rate, and then the shareholders pay tax at their rates.
However, due to the expense and complexity of creating and maintaining a traditional corporation, very few small or mid-sized businesses are set up as C corporations. Yet you can still obtain the liability protection and tax advantages offered by a corporation by setting your business up as an LLC.
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. In contrast, multi-member LLCs are taxed as partnerships. In such cases, 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.
Alternatively, you can also elect for your LLC to be taxed as an S corporation. In this case, you will be responsible for paying payroll, plus payroll taxes, and filing a tax return on behalf of the 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. In addition, there is some indication that the audit risk for S corporations is less than the audit risk for companies taxed as sole proprietors, where income and expenses are reported on your personal Schedule C.
Suppose your business is taxed as an S corporation. In that case, you will pay income taxes on your profit distributions. Still, you would save roughly 15% in payroll taxes on distributions taken as profits rather than as payroll. 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.
However, for an S corporation election to make sense, you'll want to have at least $75,000 of net income per year. To help you choose the entity that's most advantageous in terms of taxation, meet with us, your Family Business Lawyer™ or Certified Public Accountant (CPA).
- Administration & Operation
While sole proprietorships and partnerships don't offer any liability protection from the liabilities or activities of the business, both entities are simple to set up and maintain. Suppose you start a new business and are the only owner. In that case, you are automatically a sole proprietorship in the eyes of the law, or a partnership, if you have more than one owner. There is no need to register your business with the state in either case, file any paperwork, pay any fees, and there are no special rules to follow.
While LLCs and corporations offer liability protection and tax advantages, those benefits come with specific administrative requirements known as corporate formalities. These formalities dictate how the entity must be structured, maintained, and managed. And suppose you fail to adhere to these formalities. In that case, a court could remove the protective barrier shielding your personal assets, known as “piercing the veil,” leaving you personally liable to creditors in the event of a judgment.
Corporations come with the most strict and complex administrative formalities. For example, you must file articles of incorporation with the state, hold a regular board of directors and shareholder meetings, create and enact corporate bylaws, and maintain detailed record-keeping requirements, such as keeping detailed meeting minutes. Additionally, you must also file annual reports with the state and pay yearly fees to maintain your corporate status.
LLCs also comes with administrative formalities, but they aren't nearly as burdensome as those for corporations. For example, as the owner of an LLC, you must file articles of organization with the state and create an operating agreement, which governs how your LLC is structured and run. In addition, all states require LLCs to file either an annual or semi-annual report with the state agency responsible for registering business organizations.
Although there's no statutory requirement for LLCs to hold owner meetings or keep minutes, doing so provides strong evidence that you're abiding by corporate formalities. Combining diligent record-keeping and clear separation of personal and business finances, you can offer your LLC extra protection from creditors.
Should you choose to set up as an LLC or corporation, as a Family Business Lawyer™, we can offer support with maintaining your business records and the corporate formalities required. We offer exceptional maintenance packages to help ensure your entity meets these requirements and maintains the maximum level of protection for your assets.
Enlist Our Guidance and Support
Properly selecting, setting up, and maintaining your business entity is far too important of a task for you to try to handle all on your own. We offer you trusted advice on the most advantageous entity for your particular business and then help ensure that your entity is properly set up. We can also provide you with sound business systems to make your business more efficient and establish a clear separation between your business and personal finances, which is a crucial part of maintaining your entity's liability protection.
In addition, we will also ensure that you comply with the various state laws and administrative formalities required to maintain your entity and safeguard your assets, so you can remain focused on the most important task—growing your business. Contact us, your Family Business Lawyer™ today to get started.
This article is a service of R&R Legal Advisors LLC and Family Business Lawyer™. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer a LIFT Start-Up Session™ or a LIFT Audit for an ongoing business, which includes a review of all the legal, financial, and tax systems you need for your business. Call us today to schedule.