You may operate your business as a Sole Proprietor, like 70% of US businesses do, or maybe as an LLC. However, if business should become fabulous and you begin to rake in some serious cash, then it could make sense to incorporate, as a method to lower your taxes and protect profits.
You may be implementing a growth strategy that requires you to take on additional investors, or maybe implementing your exit strategy, with a plan to sell your business, perhaps to employees through an Employee Stock Option Plan (ESOP). Either scenario may prompt your accountant or business attorney to recommend that you establish a separate legal entity for your venture and the preferred strategy could be to incorporate.
What does that mean in practical terms? For a Freelance consultant or small business owner, incorporating usually means setting up an S Corporation. Last week’s post discussed Limited Liability Companies (LLCs) and there are similarities between the S Corporation and LLC.
The first similarity is that both LLC and S Corporation provide owners with a degree of protection from lawsuits and creditors. However if negligence is involved, the “corporate veil” will be pierced and the owner(s) will be liable for any damages.
Second, there are certain similarities in how taxes are handled. As with the LLC, S Corporations (unlike the more common C Corps) allow a “pass through” of business profits or losses to the owner’s (i.e., S Corp shareholders) personal tax form 1040 in accordance with the share of business ownership. There is no separate (double) taxation, as occurs with C Corporationss. Both S Corp and LLC owners can deduct pre-tax business expenses such as advertising, professional services, travel, etc. S Corporation owners will file form 1040 schedule E and form 1120S in addition to your usual tax forms.
Yet, there are a couple of differences that impact the treatment of taxes. Unlike the LLC and like the C Corporation, S Corporation owners pay themselves a salary (that must be deemed reasonable based on industry standards and business revenue) and they receive dividends (distributions) from any additional profits earned. Dividends are taxed at a lower rate than the salary pay-out and that is one reason that S Corporation tax rates may be lower.
Another difference involves self-employment taxes. Says Diane Kennedy, Phoenix, AZ based CPA and author of “Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax” (2001), “If you have a Subchapter S Corporation and you put yourself on the payroll as a W-2 employee, withholding taxes from each paycheck as you take money out of the corporation, you can often save a significant amount of money in self-employment taxes”. Sole proprietors and LLC owners must pay self-employment taxes.
Owners may sell, transfer, or gift their shares, something that cannot be done by LLC owners. There cannot be more than 100 S Corp shareholder/owners, but family members who own shares are treated as one shareholder when counting. Corporations, regardless of the form, continue on in perpetuity unless formally dissolved. Death does not automatically dissolve a corporation, while LLCs terminate if one owner retires, resigns, dies or goes bankrupt, but can be reformed if desired.
On the downside, S Corporations have more stringent guidelines than do LLCs. Owners must be US citizens or reside in the US. There can be only one class of stock and depending on the state in which you’ve incorporated, there may be additional state taxes. Businesses that receive 25% or more gross income from passive income (think rental income) and those that receive 95% or more gross income from exports are prevented from forming an S Corporation.
S Corporation owners must also hold annual board of directors and shareholder meetings and take minutes. Further, the owners must strictly separate their personal and corporate bank accounts. Failure to adhere to all requirements may result in forfeiture of S Corp status and the IRS is looking.
So which business organization strategy is best for your business? Like I said in the beginning, it depends on the circumstances. Throughout the life of you and your consultancy, it is wise to assess where you are presently and your plans for the future in terms of income, growth, exit strategy and taxes and institute the legal structure that will enhance your position.
Thanks for reading,