Choosing the Right Structure – Inside Indiana Business

0

Starting your own business is not for the faint of heart. Above all, the question of how to structure your new company from a legal and tax point of view causes a lot of headaches. Here are some of the more common types of business entities and their pros and cons.

Entity Options – What do I choose?

One-man business. The most common and least complex structure is the sole proprietorship. The “Sole-Prop” is tailored to single-owner companies. They’re easy to set up (you can use your social security number as your business ID), have little to no setup cost, and don’t require a separate tax return. As the sole owner, you have complete control of the company and keep all profits.

partnerships. Partnerships share characteristics similar to single props in that they are easy to manage and inexpensive to create. They also offer flexibility in terms of operating income, since the distribution of profits does not have to be handled pro-rata. This is beneficial in cases where a silent partner (one who provides capital but is not involved in day-to-day operations) is a key member of the company. Both sole prop and partnerships are considered “pass-through” structures because the net income reported by the partnership is taxed on the owners’ tax return and not at the corporate level. While both units have advantages, there are some glaring disadvantages.

For consideration:

  • Neither company offers personal liability protection. This implies that owners and companies are one and the same. Thus, the private assets of the owner(s) are not protected from creditors.
  • Raising capital is also a difficult undertaking. You can’t sell stocks to raise capital, and banks are often reluctant to lend to these small business types.
  • Another major downside is FICA taxes, which consist of Social Security and Medicare taxes. Net profits (less the deductible portion of self-employed taxes) are taxed at 15.3% (12.4% for SS up to IRS limits; 2.9% for Medicare).

S Corporation. What options are available if you want liability protection and a pass-through structure for one-off taxation? Join the S-Corp (It’s important to realize that unlike sole proprietorships and partnerships, an S-Corp is NOT a corporate structure, but a tax choice).

  • Once you have registered as a corporation (by default all corporations are C-Corps), you must apply to the IRS for S-Corp status in order to establish this election.
  • An S-Corp provides that protective barrier that isolates all business debt to your company itself and isolates personal assets.
  • Also, as an S-Corp, you’re technically an owner-employee, which means the compensation you receive can come in two forms: a salary and a net income distribution. Why is that important? As noted above, all single prop and partnership net income is subject to FICA. With an S-Corp, only the salary you pay yourself is subject to FICA.

For example, Joe’s tacos (a single prop) has a net income of $100,000, which is taxable income for him. In conjunction with these taxes, his self-employment taxes are $14,130 ($100,000 of net income less the deductible portion of self-employment tax (7.65%) x (15.3%)). Conversely, if Joe is an S-Corp, he could be paying himself a salary of $60,000. As an S-Corp, Joe only has to pay FICA taxes on his salary, which totals $9,180. The remaining $40,000 of profit would only be subject to income tax.

So why not just choose S-Corp status and take ALL earnings as distributions? Well, the IRS is enthusiastic about this strategy and has determined that you must pay yourself a “reasonable salary” (which is what you would pay if you hired someone for the same position) in order not to use the S-Corp as a tax avoidance workaround to use.

While the S-Corp carries many positive attributes, it also has its share of disadvantages:

  • S-Corps require a fully legal setup, which results in increased costs as you typically need the services of a lawyer and an accountant.
  • Additionally, profits and distributions must be allocated based on ownership, which takes away some of the flexibility of the partnership.
  • There can be no more than 100 shareholders, all of whom must be US citizens or residents.
  • You can also have only one share class. Thus, there can be no preferred shareholders.

Company with limited liability. The LLC (Limited Liability Company) is a hybrid of sorts, as it offers ease of incorporation and maintenance similar to that of sole proprietorships and partnerships, while offering personal liability protection comparable to an S-Corp.

  • The LLC is a legal entity only, meaning it is not a taxable corporate structure, and you can choose which tax regime is right for your business. By default, single-member LLCs follow the sole proprietorship tax structure, while multi-member LLCs reflect partnerships.
  • You can also choose to be taxed as an S corp for your LLC. Remember, an S-Corp is simply a tax election. This means it can offer additional flexibility in terms of payment structure and eventual taxation.

summary

Deciding how to structure your business can be an arduous process. If this process becomes too cumbersome, you should speak to your financial advisor for input and, if necessary, consult an attorney. Taking the time to work through the pros and cons of each structure can help you achieve better results for your business.

Mathew Ryan, MBA, CFP, EA is a financial planning specialist at Bedel Financial Consulting, Inc., an Indianapolis-based wealth management firm. For more information, please visit www.bedelfinancial.com or email Mathew at [email protected]

Share.

Comments are closed.