Everyone who starts a business is faced with the challenge of deciding what type of business entity to be. Most default to sole proprietor or sole trader. But is that always the best option? When my partners and I set up shop, I talked extensively to my accountant and did my research. Here’s what we found out.
(DISCLAIMER: I’m not a C.P.A., so this should not be construed as professional advice; nor is it intended to replace talking to an actual accountant. I should also note that since I live in the U.S., some or all of this may not apply to other countries.)
Sole Proprietorship vs. Incorporating
The simplest type of business entity is a sole proprietorship. In this scenario, there is no distinction between you and your business—you are one and the same, both in terms of taxation and legal liability. This means that if someone were to sue you, your personal assets will be at risk.
The sole proprietorship is often referred to as a D.B.A.—“Doing Business As.” So if Paula Programmer decides to start her own web development business, she is Paula Programmer “doing business as” ABC Web Development.
A corporation, on the other hand, is considered a separate legal and tax entity, and they come in three varieties: the Limited Liability Corporation (LLC), the S-Corp, and the C-Corp.
Limited Liability Corporation and S Corporation
The LLC or the S-Corp are both good options when you are first starting off and don’t expect to keep a significant amount of capital in the business. These are known as “pass through” entities, because all of the company income passes through to you as personal income, on which you can be taxed. Conversely, if the corporation loses money, you can claim that as a deduction on your personal taxes. This can be helpful when you’re a start-up and expect a loss for the first year or so.
While both the LLC and the S-Corp share the “pass though” taxation aspect, the similarity ends there. The S-Corp is considerably more complex tax-wise and legal-wise, and you may become quite well-acquainted with your accountant or tax attorney if you decide to form one.
C-Corp is the better option once you become more profitable. Here’s why.
Suppose your gross revenue for the year was $500,000, of which you took $100,000 for your personal income. As an LLC or S-Corp, you’ll be taxed on the entire $500,000 as personal income, even if you leave the remainder in the corporation’s bank account for future business purposes. But as a C-Corp, the IRS will tax you on the $100,000 and the corporation on the remaining $400,000 (so long as you paid yourself the $100K as a salary and/or bonus, not a dividend). Keep in mind that, the more money flowing into a single tax return, the more likely you’ll be kicked into a higher tax bracket. You’ll pay fewer taxes on the same amount of money if you spread the income over more than one tax return.
There are other benefits from being a Corporation, such as your business and personal debts are kept separate. So if your business goes belly up in the years to come, creditors cannot come after you personally and try to take your home. And while that sound good in theory, the reality is, if you were to apply for a $50,000 loan, unless your corporation has outstanding credit, the lender is going to require that you sign a letter of personal liability. So you still end up putting your personal assets on the line.
Another benefit is the protection from legal liability. So long as you keep up with all of the paperwork and filing that the government requires, and you don’t do anything grossly negligent, no one can go after your personal assets in the event of a lawsuit.
That’s why a LLC or S-Corp is a good choice when you’re going into business with one or more partners, like I did. Unless you incorporate, each of you is jointly and individually liable for the actions of the other partner(s). Becoming a LLC or S-Corp provides the “pass-through” tax benefit for a new business, while still protecting your ass(ets).
Always Seek Professional Advice
As you can see, there is no “one size fits all” solution. Once again, I’m not an accountant, so don’t take my word for it. Find a good C.P.A. or tax attorney that can help.
(I’m not an attorney either, but for some free legal advice—and some shameless self-promotion on my part—check out my other article, Bulletproof Web Design Contracts.)
Former owner and partner of web firm Jenesis Technologies, John is currently Director of Digital Strategy at Haines Local Search, a company providing local search marketing solutions to SMBs, including print and Internet Yellow Pages, web design, and local SEO. When not working or spending time with his family, John offers great sales and marketing advice on his blog, Small Business Marketing Sucks.