Whether you are preparing to launching a new venture or you’ve been operating as a Sole Proprietor (Sole Trader in the U.K.) for a few years, you may decide to establish a business legal entity for the enterprise. The benefits of creating a business legal entity, whether you operate as a Solopreneur or participate in a partnership that consists of independent professionals who occasionally collaborate (like dentists or physicians) or co-owners who run a business together, are:
1.) protection of business assets from (certain) financial liabilities
2.) reduced tax liability
Entrepreneurs and Solopreneurs who have no worries about legal actions that might arise from bankruptcy or other business debts (or client litigation) may comfortably operate as Sole Proprietors. Business owners of any kind, plus the self-employed, may at some point decide to organize their venture as a corporation (either the original C Corporation or subchapter S Corporation) or a Limited Liability Company (LLC).
FYI in the U.S., corporations are tax structures that are overseen by the IRS (a federal entity) and LLCs are created and governed at the state level. Application to form either entity is made at your state’s Secretary of State office or in Washington, D.C. at the D.C. Corporations Division. In the U.K., business legal structures are obtained through and governed by your regional Companies House.
Regarding protection from financial liabilities derived from a business legal entity, actions that can be construed as negligence are considered to “pierce the corporate veil” and neither a C or S Corporation, nor an LLC, will shield negligent business owners. But if the business goes into bankruptcy or serious debt, only business assets can be applied to cover those debts and if that amount is insufficient, the owner(s) will not be forced to use personal assets to pay what is owed. Furthermore, the entity will not be liable for debts that exceed the value of the owner’s investment in that entity. In other words, if an owner’s investment was $20K, that’s all the owner will be liable for, even if $30K is owed.
Now for a look at potential tax savings. Unlike the older U.S. corporate structure, the C Corporation, there is no simultaneous tax of business and personal income in the S Corporation (i.e., no double taxation) and all the usual business deductions that you’ll find on IRS Schedule C may be taken. The S Corp allows owner(s) to pay themselves and all employees with W2 salaries, meaning that owners avoid the self-employment tax if it’s decided that you work for the corporation (instead of yourself).
A portion of what can be reasonably considered excess net profits can be paid to the owner(s) as a dividend distribution, in addition to the W2 salary, and the distribution is taxed at a much lower rate (from zero- 15%, depending on circumstances) than the W2 earnings. This is one way that the rich get richer, Baby!
The owner’s salary must be considered reasonable for the industry, because the IRS will be looking. Contact a savvy tax accountant so you’ll refrain from paying yourself $20K annually when $80K would be closer to the minimum for your industry and business Income Statement. Shenanigans like that can cause the business to lose the S Corp status and land you in double-taxation-ville.
If business income is not so flush, your accountant may recommend that like a Sole Proprietor, S Corp owner(s) should choose the “pass through” tax format, where all income and expenses appear on the personal tax form(s) of the owner(s). Be advised that partnership S Corps are taxed like a partnership and S Corps that elect the pass-through tax option will pay the quarterly self-employment tax on reported income. Corporate taxes are filed no later than March 15, earlier than the rest of us.
In both the C and S Corp structure, the owner(s) is a stockholder, and multiple owners are assigned shares of company stock and receive a portion of business profits and losses according to their percentage of ownership. The S Corp allows only one class of stock.
On the downside, the rules for maintaining a corporate entity of either form are somewhat strict. S Corp owners must be citizens or residents of the U.S. and their number is capped at 100. Every corporation is required to have a board of directors or officers (the owner and a Recording Secretary to take the annual meeting minutes, at least) and even solo corporation owners must hold an annual stockholder’s meeting. Financial documents must be in good order. Minutes must be taken and kept on file.
Because there is only one class of stock allowed, those who plan to seek venture capital or take their company public must form a C Corporation, so that the preferred stock that investors demand will be available. Finally, the legal and accounting fees, as well as special state taxes where they apply, make the choice of either a C or S Corporation a four-figure annual commitment, so consider your choice of this option prudently.
Next week, we can resume the discussion with a look at the Limited Liability Company structure.
Thanks for reading,