There are many variables that come into play when determining which entity is best for your business or future businesses. Unfortunately, there was no formula for success.
As you may know, if you go to an attorney, you will get one answer (from a legal perspective), an accountant you will give a different solution (from a tax perspective), .and all sorts of solutions from your business networking group, the internet or others.
The big challenge is that there are so many prospectives to consider as to which entity is best for you:
- Business Credit
- Raising Money
NCP has interviewed dozens of law and accounting firms over the years and has discovered patterns that may help you.
For example, most new business owners will go to their accountant for advice on starting a business. Most do not have a law firm they work with, and the only professional in their life is the accountant. The accountant will ask questions about the new business to determine from a tax perspective, which is the best entity for your business. That is ONE NICHE of advice, tax only.
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 $132,900 in 2019 of earned income). Guess what happens? In most situations, the new business owner is not sure of the net profits the first year, does not have experience in the business, and 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., if you need credit, you will self finance the business. 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. Keep in mind that most banks may not issue one with a new business, some will wait until the entity is 1-2 years old, but some banks will let you 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.
The first important question you should ask yourself is, “Do I need or want a flow-through entity?” This is an entity where all the profits and losses flow to your personal return, as opposed to retaining company profits in an entity such as a C corporation.
Step 1: Flow-Through Entity versus C-Corporation. A regular C corporation is one that is primarily used for reinvestment of profits to grow the business. Typically, more equipment and labor is needed to grow the business for long term results. If your new business will grow with employees and overhead, and you are looking to grow an asset over time, a C corporation may be best for you.
Unfortunately, there is a lot of information in our industry, suggesting that a C corporation is appropriate for most people. The 21% C-corp tax bracket in may situations is lower than your overall personal rate, and therefore everyone should use a C corporation to pay overall lower taxes. That does work in year one — but unfortunately, any profit left in the corporation will be part of retained earnings, and may be subject to double taxation in years to come.
If your goals with your home-based business are to have high profits and low overhead, you probably want to have your profits flow through; pay tax once and invest the money into other assets to grow. That may be real estate, investments, or other businesses. That typically will be held in a separate entity from your operating business. Again, your goals are critical with what you are planning to do with the profits from your business after years 1, 2, and so on (assuming there are profits).
Example: A consultant (who has a different tax problem) or a plumber that provides services and has no other employees forms a C corporation. Their goal is not to add employees in the future, but to be as efficient with their business as possible, controlling overhead and increasing their profit margin. For most businesses like these, a C corporation is the wrong entity. (Granted, a C corporation does have important fringe benefits, but you do not want to obtain a few fringe benefits in exchange for paying double taxation.)
The bottom line is; if a C corporation is not best for your business model over the next 3-5 years, it is probably not the best entity for you. (Bear in mind that like anything else in life, there are exceptions.) If your new business does not fit into this category, then the next step is to evaluate flow-through entities.
Step 2: A Flow-Through Entity Is Your Best Choice. If you have determined that a C corporation is not best for you, the next step is to determine what your options are. They may include:
- S Corporation
- Single Member LLC
- Single Member LLC taxed as an S corporation
- LLC taxed as an S Corporation
- LLC taxed as a Limited Partnership
Sole proprietorships are not considered here as an option for two main reasons: from a marketing point of view, there is no value in being the owner/operator; and of course, from a liability point of view, even with insurance you may find yourself financially paralyzed.
- Do you have a business partner? If not, an LLC taxed as a partnership is not an option unless you have an existing S- or C corporation that will act as a partner.
- Do you want S corporation taxation (filing Form 1120S)? Note that we did not say “Be an S corporation,” but rather, do you want to have your entity taxed as an S corporation? This includes not only an S corporation but also an LLC taxed as an S corporation.
Keep in mind if you have foreign shareholders, C corporations, an LLC taxed as a partnership or a limited partnership, none may be a shareholder of your entity taxed as an S corporation. This is especially important if you plan to have investors down the road.
S Corporation Versus LLC Taxed As An S Corporation:
- If you have a business that will develop a net worth, the LLC taxed as an S corporation offers more protection because of the charging order.
- If you provide services and if there is not a lot of net worth within the company, then an S corporation may be fine. (Remember the shareholder rules for an S corporation taxation.)
S Corporation Versus An LLC Taxed As A Disregarded Entity:
- The Self-employment tax level for 2020 is $137,700.
- If you are already maxed out with SE taxes, will the S taxation save you enough in the Medicare portion (which is 2.9% on the amount earned above the SE limits)? You also must take into consideration the 7.65% that would be paid by the entity for payroll to you as the owner.
- As a disregarded entity, the default rule is for the income to show up on the owner’s tax return. If that is you and you have an active business, the income will show up on your Schedule C. Any income on Schedule C will be subject to SE taxes (if you are not already maxed out). The benefit of Schedule C is that payroll is not required for the owner.
S Corporation Versus LLC Taxed As A Partnership:
- First, you need to address the SE tax savings issue. If the client is in a position to save on SE taxes (15.3% of $137,700 in 2020).
- If you are a member of an LLC taxed as a partnership, your income is more than likely going to be subjected to SE taxes if earned income (unless you are a passive member and work under 500 hours).
- The members of an LLC taxed as a partnership are not considered employees, and payroll would not be required for them. The owners of the S corporation, if officers/directors will have payroll as part of their compensation.
Keep these tips in mind as you form more entities to protect your hard-earned assets. You must also keep in mind how your state handles different entities. In California, an LLC is required to pay an upfront $800 franchise tax fee, but the S or C corporation is not. (It may still have to pay the fee based upon first-year profits.) Does that mean you never want to be an LLC in California? Of course not, but it does come into play.
We’ve raised many interesting issues, and no doubt, you’ve got questions or thoughts at this point regarding your situation. If you need support with forming a new entity, reach out to our team at firstname.lastname@example.org.