What entity type should I choose for my small business?

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I’ve coached dozens of people through starting small businesses over the past decade. Everyone eventually has to decide ‘what entity should I pick? I’m not a CPA nor did I sleep in a Holiday Inn Express last night. So, please, run anything I say by your accountant. But the truth is that most people choose their first entity without understanding all of the options out there.  Worse. They often make the wrong choice.

Never let tax strategy be the tail what wags the dog. It’s unlikely that your business will succeed or fail based on the type of entity that you choose. However, the entity choice for a small business making $200,000 or year or less can easily led to a swing of $10,000 in your pocket at the end of the year based on the variables that are unique to your business and tax situation. I don’t know about you; but I’m willing to spend a bit of time and energy learning about taxes to save 10K.

Can you count on your accountant to tell you the best answer? Umm.  No. I’m not saying that you or I will necessarily know as much about tax law as a CPA, but in my experience very few tax providers take the time to truly understand what is unique about your situation such that they can make an informed decision.

Mirror, mirror on the wall; which is the fairest entity of all? “It depends”.  That’s right. The correct entity for you depends on a lot of factors that will be unique to your situation.

This article can’t go into an exhaustive discussion of all the options that exist and the pros/cons of each. It’s simply not possible in a short blog post. My goal in writing today is three fold. First, to help you understand this topic is worth a few hours of your time. Is saving thousands of dollars a year worth a short investment of your time? Second, I want you to know that you that you can’t blindly assume your CPA will give you the best answer. Hopefully they are an expert on tax law. But they aren’t experts on your business and personal finances. Understand the variables and make an informed decision. Your bank account will thank you.  I’ll give you a tip on how to better understand the variables that go into this decision the end of this article. And third, I want to draw your attention to an entity type that few people know exists and that just might be the best choice for your fledgling business; especially if you are a looking at a simple company to handle consulting, writing, and speaking income.  

Most people understand the basics of a ‘pass through entity’ and tend to focus their analysis on an LLC, s-corp, or a full c corp. Generally, small service businesses end up choosing either an LLC or an s-corp. But did you know that most states allow you to create an LLC and then elect to be treated as a corporation? Normally, an LLC would be treated as a sole proprietorship if it has just a single member or a partnership if it has more than one member. However, LLC’s can choose to be treated as a corporation for tax purposes you could then choose the sub chapter S-election.

Did you catch that? An LLC can actually be treated as one of 4 different types of entities for tax purposes. Most people don’t seem to know that and I’m surprised at the number of tax professionals that never seem to point this out to clients.

Personally, I think an LLC that is taxed as an s-corporation tends to be one of the best structures for a small business especially those focused on services. I like LLC’s since they are simpler and tend to cost a bit less to maintain that a full c-corp. However, owners of an LLC will often end up paying a higher amount in payroll taxes. This is because an owner of an LLC that is treated as a sole proprietorship or a partnership will generally end up paying payroll taxes on their net proceeds while an owner of an s-corporation can pay themselves a fair market salary and take a portion of their proceeds as a distribution which escapes payroll taxes. You can quickly run afoul of the IRS by trying, for example, saying that your fair market wages are $100 a year while making $100,000 and try to treat the rest as dividends. Chances are that would not be a fair market salary trying to game the system like that would be tax fraud. I do not encourage this. But, there are many times where this apparent loophole can be used to lower the amount of money that you need to treat as wages subject to payroll tax.

What’s the bottom line?

Anyone thinking about starting a new company that is considering an LLC should take a look at creating an LLC that chooses to be treated as a corporation and then takes the sub chapter S election. Often, your CPA might not even mention this option to you. I don’t know why. But I do encourage you to explore whether or not it might be a good fit for your specific needs. In any event; I encourage you to understand the basic differences between an LLC, S-corp, and a c-corp and to spend a few hours mapping out what your tax obligations would look like under each approach. Like I said, making the correct choice can easily save you thousands of dollars a year.

I encourage you to check out this article http://bradfordtaxinstitute.com/Content/Is-S-Corp-Best-Entity.aspx if you’re interested in learning more on this topic. You can register and get a trial subscription to the www site for free. Monthly subscriptions cost $20 and annual plans are less. It’s far and away one of the best sources of tax planning info for small businesses that I’ve run across. And no; I don’t get a referral fee if you subscribe.  The article does a fabulous job of helping you understand the pros and cons of different entity types based on different financial and business circumstances you might have. You should be able to read and absorb it in less than 15 minutes. Certainly no more than 30 minutes. And it might save you a ton of money over the course of your business. Read it. Now.

 

 

 

 

 

 

 

 

 

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