You have your idea and a plan to bring it out to the world. What’s the next step? One thing you can do is just follow through with your plan and get your company running. This way, your legal structure is very simple and it’s also the easiest to initiate; mainly because you don’t have to do anything! Sounds great, right? No paperwork, no filings, no dealing with the IRS, just off to the races!
Hold up, the problem with this is that there is no separation between you and your business. If there is a lawsuit against your business and you lost, you will also be held personally responsible. So while sole proprietors are the simplest entity, I would argue that it is also the riskiest.
Limited Liability Companies
To separate your business from yourself, you must set up a separate legal entity. One form of this is an LLC. LLCs are relatively easy to set up; it varies by state, but usually just requires a simple application and a small fee. This is the first crucial step to getting your business off the ground. Keeping personal assets separate from business assets will not only make financial decisions easier, but it will keep your CPA happy.
The one problem with LLCs is the tax consequences. Members of an LLC are treated as self-employed from a tax perspective. This means that income the LLC generates will flow through to the individual, and the individual will pay income tax as well as self-employment tax on all of that income. This is a huge 15.3% of your income!
S-Corporations are the next option that an individual has as a legal structure. This structure has the same benefit of an LLC in that it will keep the business assets separate from the individual assets. It will also keep any liability separate as well. The drawbacks are that there can only be 100 shareholders, and none of the shareholders can be other companies. S-corps also have to perform bureaucratic duties to remain compliant, including issuing stock, passing bylaws, and holding shareholder and director meetings.
The huge benefit here is the tax treatment of the self-employment tax. Any income that the S-Corporation generates will flow through to the individual and will be subject to income tax. However, there will not be any self-employment tax! To properly pay your share of self-employment tax, the individual will have to pay himself a salary from the corporation. Here is an example:
Alejandro owns Desk Corporation. This year, Desk Corporation generated $100,000 in revenues. Desk Corporation pays Alejandro a $40,000 salary. Since this salary is an expense to the corporation, the Net Income that it will report is $60,000. Now, Alejandro will only pay self-employment tax on his $40,000 salary, while the other $60,000 remains self-employment tax-free (keep in mind, both of these are still subject to income tax).
There are a few other legal structures to cover, but I will go over those next time. I hope you found this information helpful and of course, contact me if you have any questions.