So you’ve finally decided to start your own business… and now what? What do you do next or how do you actually set up your own business so that you’re operating as a business entity and have the proper legal structure? Here’s a quick summary of the options that you will have to consider.
But before I start, let me add a quick disclaimer. Please note that I’m not either a legal or accounting expert and what you’re about to read is merely the result of my own research and my own experience. I strongly recommend that you seek professional help that will advise you about all the legal options and tax treatments as they apply to your particular case. A corporate attorney and an accountant should always be part of your advisory team.
With that said, the question that I get asked more often by other people and friends wanting to set up their own business is whether they should incorporate or set up an LLC or what type of business entity is best for them. The real answer is that “It depends.” It depends on a lot of factors, and obviously there are tons of books out there that already explain the differences between the different business structures, so I won’t dig deep into each of the legal structure’s specifications here.
Suffice it to say that the whole topic of describing the different business entities is quite confusing. You need to have a clear understanding of the differences between the actual business and legal structures and the tax classifications or tax treatments of each of those structures. In terms of legal structures, when you set up a new company in most states you can select between a C Corporation, an S Corporation, or a Limited Liability Company (commonly known as LLC). One of the reasons why LLCs have become so popular recently is because the LLC provides you with the Liability protection of the S or C Corp, but without all the legalities, paperwork and guidelines required when you form a Corporation. In addition, the cost of setting an LLC is also minimal, typically around two hundred dollars depending on your state. These two reasons alone make the LLC option very attractive and effective business structure for new entrepreneurs.
When it comes to the tax treatment of each of the business entities is when it gets a little more confusing. The main reason is because the LLC is a business structure allowed by state statute; however it is not in itself a tax entity or classification that is recognized by the IRS. Depending on the elections made by the LLC (you and your LLC members in this case) the IRS will treat the LLC as either a corporation, partnership or as part of the LLC’s owner tax return also known as a “disregarded entity.” So, now I have you all confused, right?
What the above means is that in effect, the IRS only recognizes four different business Tax Classifications:
- Sole Proprietorship
- S Corporation
- C Corporation
Notice that none of the above IRS classifications includes the LLC. That’s because if a domestic LLC includes at least two members, the IRS will automatically classify it as a Partnership for federal income tax purposes. So, even if your “legal” structure and formation within your state is that of an LLC, your default tax classification assigned by the IRS will be that of a partnership. By the same token, if you form a one member LLC, (with no partners), the IRS will treat you as an entity disregarded as separate from its owner for income tax purposes. It is important to keep in mind that the LLC is a “pass-through entity,” which means that all the income and expenses from the business get reported on the LLC member/s personal income tax return. In other words, the profit or losses from your business will be factored in and be part of your adjusted gross income when you prepare your personal tax return. By the same token, single member or partners of the LLC are required to pay self-employment tax on income generated in the LLC, which means making quarterly estimated payments to the IRS.
Alternatively, if the LLC files Form 8832 (Entity Classification Election) it can affirmatively elect to be treated as a corporation rather than the above default tax classifications for federal tax purposes. Why would you want to do that? Mostly, because in some cases, it may be advantageous for you to keep the legal structure of the LLC while being taxed as an S Corp.
Here’s a specific case scenario. Let’s say that you decide to start your own business either by yourself or with a partner. In both cases you (and your partner) will need to report all profit or losses from your new LLC on your personal tax return. As a new LLC, it is very likely that in the first few months or even the first year, the cost of operating your business exceeds your income. Therefore, you “pass through” the loss from your business to your personal tax return, which in turn, becomes a reduction of your adjusted gross income. Now we fast forward a few more months and your business starts to really take off and become more successful. Your profits increase and with that, your tax liability also increases. At that point, you get together with your accountant, and he may suggest to you to elect to be taxed as an S Corp while keeping your LLC intact. As a result of that, you start drawing a salary from your company and receive the rest of your profits as monthly, quarterly or semi-annual dividends that are taxed at a lower tax rate. The very important rule in this case is that you must assign yourself a reasonable salary equivalent of what a person in your same position would normally make. By doing that, you will have the best of both worlds: you can keep the simple structure of the LLC while being taxed as an S Corp, therefore saving you money in legal fees and on your tax return.
You will notice that I have not mentioned the C Corporation as an option in this article. That is because the way C Corps are taxed by the IRS is a major drawback to this type of entity for the small business entrepreneur. The federal tax code requires a corporation to pay taxes on its income before any distribution is made to its owners. Each of the individual owners must then pay tax on the income they receive from the corporation. The result is that you end up with double taxation situation with corporate income is taxed twice, not a desirable situation for the small business entrepreneur.
To recap this article, starting your own business is a great decision to make. I’ve started several businesses myself and I’m very proud of each of them. But like everything else in life, the more information you gather, the smoother your new entrepreneurial journey will be. I must admit that I didn’t have a lot of information available when I started my first business and frankly, it was before the Internet even existed so I couldn’t even research as easily as I can today.
There’s one book that I definitely recommend to all of you. You can also find it in the “Book Recommendations” section of this Blog and I refer to it all the time.
Let me know if you have questions and please leave any comments below if you would like to share your own entrepreneurial experience.
Until next time, this is Manuel Gil del Real (MGR)