The common pattern we have noticed over the years from the accountants and CPAs is;
if you do not expect to net $40,000 per year in net profits, keep it simple and be a sole proprietorship. If the business were to generate $40,000 in net profits forming an S corporation would help save in employment taxes (15.3% of $142,800 in 2021 of earned income).
Guess what happens?
In most situations, the new business owner is not sure of the net profits the first year and does not have business experience.
Therefore, the tax professional will conclude.
“You should keep it simple and be a sole proprietorship, and after the first year, if you make enough in profits, let’s consider forming an S corporation.” The tax professional will continue to say, “If you have liability, you should consider liability insurance.”
Does this make sense? Is this the best approach?
(By the way, in our research this is the main reason that over 67% of all small business in the U.S. operates as sole proprietorships (that includes all the people in the MLM or direct sales industry).
In our opinion and research, the answer is a big NO. Why?
The tax professional is correct from a tax perspective, one prospective only. But from a legal, asset protection, audit rate, marketing, financing, and business credit perspective, that was the WRONG answer. In other words, you would have been 1 out of 7, not a good batting average for success.
Let’s cover one in detail.
Why is the sole proprietorship the wrong entity from a business credit and financing perspective?
When you operate as a sole proprietorship in the U.S., you will self-finance the business if you need credit. That means using your personal credit cards. As you use your personal credit cards, you will jack up your revolving debt, which will drive down your personal credit score. There are other types of financing, but this is the most common. Now, a year goes by, your business is taking off (hopefully), and you visit with your accountant again and find out that it is recommended that you now form an S corporation because, in year two, your profits may be over that $40,000 per year level.
One important step with the new entity is to apply for a business credit card in the name of the entity under the EIN. Remember that most banks may not issue one with a new business, some will wait until they are 1-2 years old, but some banks will apply with a brand new entity. They do that because evaluating whether or not your business will qualify for a business credit card depends upon mostly personal factors, your personal credit score, your personal revolving debt levels, do you have any major deragatories (like a bankruptcy or foreclosure). Why is so much personal information required? Because with a new S corporation, there is no business history, and the approval is based upon your personal credit.
Does that mean a business credit card is useless?
No. A business credit card in the name of the entity under the EIN, even though it will be personally guaranteed, the debt will NOT show up in your personal credit bureaus. That is huge! That helps to protect your personal credit moving forward. You would have been better off forming an S corporation from Day 1 and stop using your personal credit cards to finance your business. Since your accountant or CPA does not specialize in business credit, you will not get this part of the equation.
This is why forming an entity online is like a crap-shoot.
Odds are you have only one or two criteria to determine what entity is best for you. You might guess right, but why guess? By the way, the accountant is not going to tell you about an LLC taxed as an S corporation because that involves a different perspective.
Does that mean your accountant is bad? Of course not? It just means that it is only one perspective.
Additional Key Questions to Determine Which Entity may be Best for Your Business
The first important question you should ask yourself is, “Do I need or want a flow-through entity?” This entity is where all the profits and losses flow to your personal return instead of retaining company profits in an entity such as a C corporation